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A Seasonal Healthcare Portfolio Using VHT

Summary At the request of a reader, I modified my previous biotech portfolio to focus on healthcare. The result of applying the seasonal data of the healthcare industry was a portfolio that outperformed buy-and-hold strategies, both on VHT and SPY. This six-trades-per-year strategy produces improved performance and dividends with decreased risk. (click to enlarge) Another reader request for a modification of the seasonal biotech portfolio : In this case, Lisa wants to build a seasonal portfolio that can effectively invest in the Vanguard Health Care ETF (NYSEARCA: VHT ). I will help her develop such a strategy and back test it against a buy-and-hold strategy, as well as holding the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ). Why VHT and not XLV? Though I thought about using the Health Care Select Sect SPDR ETF (NYSEARCA: XLV ) instead of VHT, as it is immensely more popular than VHT as a tool to gain exposure to the health care industry, I decided that Lisa was right in her first choice of VHT. An important reason to use VHT in place of XLV is its dividend. In a seasonality based portfolio, we will be ditching the healthcare ETF at certain times to avoid the opportunity cost associated with the healthcare down season. However, both VHT and XLV pay out dividends. So, another downside arises: missing out on the dividend. VHT is the superior choice here because – as you will later see – we will always be holding VHT at the ex-dividend date, allowing us to gain all the dividends of VHT while not being forced to hold the ETF during underperforming seasons. VHT’s ex-dividend date for its annual dividend (XLV pays quarterly dividends; hence the problem) is usually in December, which is a good time for healthcare stocks. However, this year, the ex-dividend date was in late September. But this does not damage our strategy, as we will also be long on VHT in September. The Seasonality In my original strategy on the seasonal portfolio strategy for the iShares Nasdaq Biotechnology ETF (NASDAQ: IBB ), we were long on IBB during November to January, long on utility stocks via the Energy Select Sector SPDR ETF (NYSEARCA: XLE ) from February to May, and stayed out of the market the rest of the year (sell in May), with the exception of holding gold during September, which is when gold tends to outperform. However, simply replacing IBB with VHT in this strategy is arbitrary. Hence, I looked into the seasonality of the health care sector. I found many academic studies on the subject in scholarly journals, most of which concluded the same thing: Health care does best in the fall and winter. A study performed by Equity Clock over the past 20 years produced the following image and the one you saw at the beginning of the article, which both generally sum up what the journals were telling us: stick with health care during fall and winter but drop it afterward. This leaves us with some clear modifications to our previous seasonal portfolio. The act of holding VHT from September to February changes our strategy in the following ways. We no longer need to hold gold, as VHT’s seasonality overlaps with gold. VHT’s seasonality slightly overlaps with XLE, reducing our exposure to XLE by one-third; we will still be in by the ex-dividend date. If we do not add anything to our strategy, we will only be holding two ETFs all year: VHT in the fall and winter; XLE in the spring. So what about the summer? Do we just stay out of the market? Jeroen Blokland, Seeking Alpha contributor, has already answered this question. The solution, according to Blokland, is to hold the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ). This gives us a complete strategy: At February’s close: Sell VHT and Buy XLE A few days before April’s close (check IEF’s ex-dividend date for May): Sell XLE and Buy IEF At August’s close: Sell IEF and Buy VHT The Dividends Ignoring the performance of this strategy and looking at dividends alone, we see we gain exposure to all the dividends we can. A different strategy – for example one in which we buy XLE after March or VHT after September – could result in a drastically lower amount of dividends payouts. It is mere coincidence – and luck – that the strategy that should perform best also gives us full dividend exposure. VHT: Receive one annual dividend payout in September (or possibly December). XLE: Receive one quarterly dividend payout in March. IEF: Receive five monthly dividend payouts (we’ll be on the cusp ends of both May and September’s dividend payouts). And that’s in addition to the performance we can expect from the seasonality of these industries. Let’s now see how this strategy measures up: Results and Conclusion for Investors First, a notation issue: SPY_HOLD: Holding the SPY year-round VHT_HOLD: Holding the VHT year-round SECTOR: The strategy as outlined above The results: As you can see, the SECTOR strategy gives us the best risk vs. reward ratio. The strategy would have allowed us to reduce the downdraw resulting from the 2008 market crash while maintaining a level of growth exceeding both the SPY and the VHT alone. This portfolio has the highest Sharpe ratio – 0.78 – with the lowest max drawdown – -31.37%. In 2014, had you applied the three different portfolios with $100,000, the dividend payouts would have been (without reinvesting dividends): SPY_HOLD: $1832.01 VHT_HOLD: $1130.56 SECTOR: $487.24 (from XLE), $862.12 (from IEF), $1200.71 (from VHT) = $2550.07 Notice that the dividends we receive just from the VHT part of our portfolio exceed that of a VHT buy-and-hold strategy. This is because we are buying VHT with more than $100,000, as XLE and IEF grow our $100,000 into more capital to be used for the VHT purchase. Thus, we come out with more shares of VHT, equaling more dividends, even though we bought VHT later than buy-and-hold investors, whom we can assume bought the stock at a lower price. Overall, this strategy has three main advantages over the buy-and-hold strategies we looked at. First, it has improved cumulative performance. Second, it has the lowest max drawdowns. Third, it has the highest dividend payout. What’s the downside? I can think of two. First is the tax issue, which varies across individuals. If you’re playing this in an IRA, you can come out okay. The second is the increased commissions, as you’ll be making six trades per year, as opposed to one. In the end, you must decide whether the time invested in a seasonal strategy is appropriate for the increased gains and dividends. If you’re interested in seeing some tweaks to this strategy, ask me in the comments section or via mail. I’ll be rolling out my premium Seeking Alpha backtesting newsletter soon, in which I backtest your strategies. For example, if you want to see the above SECTOR strategy tested with different ETFs as the forerunners, just leave your ideas below.

FDD: Weighing Risk With Return

Top weights ‘best-in-class’ European based global companies. Has traded in a very steady range with steady distributions for over six years. The fund maintains a cyclically sensitive bias, with its heavy weighting on the financial sector. It’s beginning to look as though the “New Normal” will indeed be a new normal for some time to come. With few exceptions, most of the global economy has lost a lot of growth momentum after many years of what seemed like limitless expansion. The most recent Organization for Economic Co-operation and Development (OECD) ‘ Global Economic Outlook ‘ reported that “… A further sharp downturn in emerging market economies and world trade has weakened global growth to around 2.9% this year – well below the long-run average – and is a source of uncertainty for near-term prospects… ” The traditional response to an economic slowdown has always been to increase the amount of cash in the banking system and at the same time lower benchmark interest rates. This in turn lowers consumer and business interest rates. The basic principle behind ‘Quantitative Easing’ is that consumers and businesses would be more inclined to borrow for durable goods, inventory, home buying or home construction and so on, thus creating demand which leads to more hiring. As one might expect, there’s a downside to “QE”. Lowering government benchmark interest rates works its way up the government bond market ladder. So, for example, pension funds will receive lower interest rates when they purchase government bonds which in turn affect their actuarial projections to meet pension payout expectations. Also, when short term savings rates decline, consumers will be less inclined to purchase short term certificates of deposits, hence reducing demand for a popular bank product. Last, but by no means least, is that individual investors will receive smaller distributions from their portfolio’s cornerstone government bond funds. A confluence of events stemming from the credit market collapse in 2008, in addition to the recent economic contraction in the Asia-Pacific region has made most QE programs virtually ineffective. The point of the matter is that the individual investor’s cornerstone fixed income may be safe, but may not contribute meaningfully to the overall portfolio for many years to come. One way to replace the loss of distributions in government bond funds without incurring exceptional risk, is through diversifying among high-quality equity, dividend focused funds. One suggestion would be the First Trust Dow Jones STOXX European Select Dividend 30 Index ETF (NYSEARCA: FDD ) . The underlying index is the STOXX® Europe Select Dividend 30 Index (Zurich: SD3P) which is designed to … track high-dividend-yielding companies, across 18 European countries: Austria, Belgium, Czech Republic, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom… The fund provides relatively good return by any standard: a trailing twelve month yield of 4.45% and an SEC yield of 5.02%. The STOXX index itself has a yield of 5.57%. There is a 0.60% net expense ratio which is much higher than the industry average 0.44%. (click to enlarge) The fund was incepted in August of 2007 closing its first day of trading at $30.75. It had declined considerably since then, tracking the STOXX index down over the years closing November 13, 2015 at $12.42. The Price-Dividend History Chart demonstrates that the fund peaked in October of 2007 at $32.26 per share and declined as housing and credit bubbles deflated, dragging global markets down with them. The fund reached its all-time low of $7.75 a share in March of 2009. It recovered by mid-2009 and has since traded in a steady range from $10.86 to $16.04. The pertinent questions investors should ask is, first, whether the fund is able to continue to produce the steady 4.45% distribution and, second, are the returns worth the risk. The best way to answer these questions is to step through the fund’s holdings sector by sector. First, it’s a good idea to understand the fund’s geographical distribution and then its sector allocation. As the pie chart below demonstrates, the fund is heavily weighted in Europe’s top performing economies, in particular, the United Kingdom, Switzerland France and Germany. Data from First Trust Knowing the geographic allocation, it’s now a good idea to chart-out the fund’s sector distributions. Data from First Trust Clearly, the fund is heavily weighted in Financials. Generally, the financial sector is cyclical, that is, it rises and falls with the economy. On the other hand, the second heaviest weight is in Utilities, a non-cyclical sector; it continues to perform regardless of the economy. Similarly Heath Care is non-cyclical, as well as Consumer Staples. Telecom is considered sensitive to the business cycle; however, mobile communications create efficiencies and productivity so Telecom services might not be as sensitive to the business cycle. Similarly, both the Energy and Industrial Sectors are sensitive to the economy, but not nearly as much as Consumer Discretionary or Materials. It seems that overall, the fund is weighted a bit more towards sectors which rise and fall with the economic tide. As to the degree of sensitivity, that would depend on the individual holdings as discussed below. The financial sector includes Europe’s premier banks, insurance and real estate investment. All of these companies are European multinationals and the top weighted funds of this sector have global reach. Three of the 14 holding have payout ratio in excess of 100% of adjusted earning, and those for which no information was available, a percentage of operating cash flow has been substituted. The average yield of the sector is 4.425%. Excluding extreme or absent values, the rough payout ratio average is 70.5%, high but sustainable. Financials 44.92% Symbol Yield Fund Weight Payout Ratio P/E Debt to Equity 5 Year Dividend Growth Rate Primary Business Amlin PLC OTCPK:APLCY 4.14% 5.76% 90.62% 14.37 17.68 6.19% Enterprise insurance and reinsurance Swiss Re OTCPK:SSREY 7.70% 4.28% 71.57% 9.06 33.10 35.92% Reinsurance, property and Casualty Provident Financial OTCPK:FPLPY 2.91% 4.08% 76.59% 26.43 257.46 9.07% Financial services, personal credit and other consumer lending Zurich Insurance OTCQX:ZFSVF 6.46% 3.98% 517% of cash flow 10.30 35.00 4.71% General insurance, consumer and commercial insurance Swiss Prime Site OTC:SWPRF 4.82% 3.31% 89.65% of cash flow 15.05 82.14 1.38% REIT: office and retail Standard Charter OTCPK:SCBFF 1.52% 3.12% 106.85% 14.06 190.27 6.22% International banking, Islamic banking, private and retail services SCOR OTCPK:SCRYY 3.99% 3.09% 26.51% of cash flow 11.39 43.95 6.96% Reinsurance, life, property and casualty, aviation, marine Allianz OTCQX:AZSEY 4.35% 3.02% 46.96% 10.83 53.82 10.81% Holding company for Allianz, insurance and asset management PSP Swiss Property OTC:PSPSY 3.81% 2.64% 88.91% 23.34 47.77 NA Holding company for real estate investment and management Banco Santander SAN 4.68% 2.58% 117.65% 9.19 240.76 0.80% Retail and Private banking; Asset management and insurance Muenchener Rueckversicherung OTCPK:MURGY 4.32% 2.49% 39.18% 9.11 15.73 6.15% Holding company; business and reinsurance, health and asset mgnt Skandinaviska Enskilda Banken OTCPK:SKVKY 5.18% 2.28% 49.68% 11.44 561.00 36.56% Sweden merchant bank; retail, corporate and institutional banking Unibail-Rodamco OTCPK:UNRDY 3.89% 2.26% 42.66% 12.25 87.70 NA French: commercial real estate investment; European shopping centers Baloise Holding OTCPK:BLHEY 4.18% 1.94% NA 9.54 33.03 2.13% Insurance, banking, retirement services Data from Reuters and Yahoo! Finance The Utility sector accounts for four holdings with an average yield of 6.09%. However, the payout ratios indicate that a few of these companies are distributing dividends nearly equal to or in excess of adjusted earnings. Hence it a strange twist, it seems that the financial sector’ dividend distributions are more stable than the utilities. Utilities 14.36% Symbol Yield Fund Weight Payout Ratio P/E Debt to Equity 5 Year Dividend Growth Rate Primary Business SSE Plc OTCPK:SSEZY 5.92% 4.95% 161.35% 27.09 100.33 4.78% UK mainly electric utility; natural gas distribution and storage Snam SpA OTCPK:SNMRF 5.15% 3.82% 19.10% of operating cash flow 13.75 190.00 4.56% Italian natural gas distribution, treatment, management; owns distribution infrastructure United Utilities OTCPK:UUGRY 3.94% 3.62 94.76 24.12 249.98 1.91% UK water and sewage management Fortum OTCPK:FOJCY 9.35% 2.19% 53.88% of operating cash flow 2.60 44.15 5.39% Finland based delivering electricity and heat and related services. Data from Reuters and Yahoo! Finance The Healthcare sector is solid with two world class, well established pharmaceutical companies: Glaxo-Smith-Kline (NYSE: GSK ) and AstraZeneca (NYSE: AZN ) . The holding BB Biotech (OTC: OTC:BBAGF ) is listed by the fund as a ‘materials company’. However, after double checking with several sources, including the company’s home page, it best described as an investment company specializing in Biotech companies. Since the return is a function of the Heath Care sector it seems logical to include this company with the Health Care sector. Health Care 7.36% Symbol Yield Fund Weight Payout Ratio P/E Debt to Equity 5 Year Dividend Growth Rate Primary Business GlaxoSmithKline GSK 5.82% 4.02% 39.40% 6.85 304.36 5.57% R&D pharma, vaccines, consumer health care. A premier global pharmaceutical company; 84 production facilities in 36 countries AstraZeneca AZN 4.36% 3.33% 141.51 47.89 63.10 4.01% R&D biopharmaceuticals for cardio-vascular, oncology, autoimmunity and more. Premier global in over 100 countries BB Biotech BBAGF 4.02% 2.96 15.84 3.75 0.00 125.74 (Labeled as Materials) Investment Company specializing in Biotech seeking researching Alzheimer’s, HIV, Hepatitis C, hypertension, hematology, diabetes and cancers Data from Reuters and Yahoo! Finance Telecommunication Service seems ‘ordinary’; however one holding, Orange (NYSE: ORAN ) qualifies as an NYSE-ARCA listing. Telecoms often have high payout ratios and that seems to be the case here. Telecom Services 7.23% Symbol Yield Fund Weight Payout Ratio P/E Debt to Equity 5 Year Dividend Growth Rate Primary Business Proximus OTC:BGAOF 3.64% 2.78% 7.973% of operating cash flow 22.54 68.78 -11.57% Belgium landline and mobile, telephony, internet and television Orange ORAN 3.82% 2.32% 110.24 46.42 114.76 -11.53% French serves France, Spain, Poland, Africa and Middle East Swisscom SCMWY 4.31% 2.08% 298% of operating cash flow 15.45 185.67 1.92% Switzerland and Italy: enterprise and residential, broadband, television, data, mobile and landline Data from Reuters and Yahoo! Finance The energy holdings are Royal Dutch Shell (NYSE: RDS.A ) and Total (NYSE: TOT ) . Again, both are leaders in every area of energy and with a far reaching global presence. Energy 7.17% Symbol Yield Fund Weight Payout Ratio P/E Debt to Equity 5 Year Dividend Growth Rate Primary Business Royal Dutch Shell RDS.A 7.24% 4.01% 187.27% 107.49 31.26 2.28% Well-to-Distilled Product-to-End Product global Oil and Gas energy company operating in over 70 countries Total TOT 5.63% 3.13% 195.03% 33.42 44.59 0.42% Well-to-Distilled Product-to-End Product global Oil and Gas company operating in over 50 countries Data from Reuters and Yahoo! Finance BAE Systems (OTC: OTCPK:BAESY ) is a well-respected aerospace-defense company often involved in state-or-the-art defense projects, joint U.S. defense projects and is considered as the premier weapons developer of the U.K. Carillion (OTC: OTC:CIOIY ) seems to operate a unique niche as a global support and service provider for ‘public-private-projects’ construction in aviation, commercial, rail, roads, utilities, and other areas as well. Industrials 6.66% Symbol Yield Fund Weight Payout Ratio P/E Debt to Equity 5 Year Dividend Growth Rate Primary Business Carillion CIOIY 5.73% 3.79% 64.23% 12.42 65.38 3.98% Support Services for public-private partnerships, construction in the U.K., Middle East and North Africa BAE Systems BAESY 4.69% 2.73% 93.44% 19.93 156.72 5.08% Aerospace, cyber security, electronics, and defense with divisions in the U.S. and U.K. Data from Reuters and Yahoo! Finance The last table contains combined, the one consumer staple and the one consumer discretionary companies. Consumer Staples and Discretionary Symbol Yield Fund Weight Payout Ratio P/E Debt to Equity 5 Year Dividend Growth Rate Primary Business J Sainsbury OTCQX:JSAIY 4.83% 5.75% 47.5% of operating cash flow NA 49.94 -1.45% UK Consumer Staples: supermarkets and convenience stores, online grocery and general retail good. Also in joint ventures for banking and insurance UBM OTCQX:UBMPY 4.16% 3.52% 76.36 20.42 80.43 -2.52 UK Consumer Discretionary: B2B media and marketing, communications, tradeshows, live events Data from Reuters and Yahoo! Finance All in all, a common thread seems to be that whatever European ‘best-in-class’ companies qualify under the fund’s objective, then they are included in the fund. First Trust lists the fund’s P/E as 13.27, price to book at 1.44, to cash flow, 10.33 and to sales, 0.84. The average 30 day trading volume is 80,874 so it shouldn’t present too much of a challenge to acquire a position. Overall, the fund seems to be well grounded with those premier holdings; however, it does stretch out a bit on the risk curve with others. The argument may be made that European banks have survived the worst of all possible situations and that, although it may take more time they will regain strength. If so, the fund is like to experience share price gains. There’s only one caveat: ECB President Mario Draghi has indicated that the European Central Bank might further weaken the Euro to stimulate growth. This might be balanced out by the strong Great British Pound Sterling and the Strong Swiss Franc. Also, the U.S. Federal Reserve Bank has also indicated that it might increase, slightly, its benchmark rate, hence creating a stronger dollar. This all might affect the fund’s yield by currency translation but, again, that greatly depends on the size of the Fed rate hike. All in all, the fund might not replace the safety of a government bond fund, but risk-wise, it seems to be on par with muni funds and then with a better yield.

The Natural Gas Market Isn’t Heating Up

Natural gas prices remain low. The storage buildup was 49 Bcf – higher than normal for the season. Extraction season should start in the coming weeks. The rise in production efficiency more than offsets the drop in rigs. Even though the natural gas market is getting closer towards moving from injection to extraction season, the price of natural gas remains low. This upcoming winter is still expected to be warmer than normal. And the rise in efficiency in producing natural gas more than offsets the decline in operating rigs. This trend will keep production higher than last year, which could keep pressuring down the price of natural gas. The recent EIA storage report showed another buildup of 49 Bcf; it wasn’t far off market estimates but was still higher than normal. When it comes to the futures markets, a lot has also changed there, as you can see in the following chart of the differences among prices of near term (next month) and future months. (click to enlarge) Source: EIA Right before the end of October, the contango in the futures markets picked up – an indication for a rise in expected future price of natural gas in the coming months. Since then, however, the contango has contracted and the prices have converged to a narrow spread. This could suggest the market doesn’t anticipate the price of natural gas to sharply rise anytime soon. For holders of the United States Natural Gas ETF (NYSEARCA: UNG ), this could result in a more modest adverse impact from the contango on its pricing with respect to the spot price due to lower roll decay. Looking forward, the market still projects the EIA will report additional buildup in storage next week albeit at a much slower pace; the storage depletion will be reported the following week – at a lower rate than the 5-year average. The EIA, in its recent monthly outlook , expects the U.S. storage will drop to 1,862 Bcf by the end of March – the end of depletion season; this will reflect a modestly lower than average withdrawal from storage due to warmer than normal winter. The EIA projects the overall demand for natural gas will only slightly rise in 2016 compared to 2015 – most of this gain will come in the industrial sector that will offset the decline in power and residential/commercial sectors. But if natural gas prices were to remain this low for a while longer, this may push even further up the demand for natural gas in the power sector, which already is expected to experience a sharp gain in consumption in 2015 of nearly 17%, year on year. These projections don’t vote well for natural gas producers, which have already suffered this year from low oil prices. In terms of rigs, according to the latest update from Baker Hughes , the natural gas rotary rig count fell again by 6 rigs to 193 – nearly 45% lower than the levels recorded last year. Although production has recently declined – as of last week, U.S. natural gas production slipped by 0.5% week over week and is only up by 0.8% for the year – the EIA still estimates production will be up by 6.3% for the year and 2% next year. The higher efficiency of gas producers will more than offset the drop in rig activity. But if prices were to remain this low, this may eventually lead to a slower growth in output as producers scale back on projects and cut capital spending. The natural gas market is likely to remain soft in the near term even as it turns into the extraction season. Unless the winter outlook changes or the number of operating rigs start to tumble down again, prices aren’t expected to rise much higher than their current levels in the near term. For more see: Natural Gas is Still Floating… Barely