Tag Archives: ideas

2016 Investment Strategy With ETFs Part 1

ETFs are transforming. According to PWC (2013) exchange traded funds have benefitted over 20 years from massive growth due to their fine advantages for investors. By August (2013) it is reported that global ETF assets stood at $2.2 trillion in assets. This two part series will look at how the ETF industry has been changing and what this means for investors. As PWC explains: Evolving and proliferating as the attracted new users, ETFs went from a single vehicle providing exposure to large cap US equities to thousands of products representing a dizzying range of asset classes and strategies. What is an ETF? Understanding this change is helpful for investors, but before progressing further, it is helpful to understand what an ETF is. Mitch Tuchman (2013) writing for Forbes does a good job of explaining this. He explains that an ETF is a type of an index fund because it has the same goal. The goal of the ETF is: To provide investors with a benchmark return at minimal cost. There is one very important difference between ETFs and index funds. Index funds are expensive to trade, but ETFs have the advantage of being traded commission free in many cases. It is explained that not all ETFs work in the way that they copy index funds, so some caution needs to be taken during the selection process. It is argued that the flexibility of an ETF with its low trading cost, along with the performance of an index fund is likely to be best achieved by utilizing the biggest and best known ETFs on the market. These are the ones that have proven ability to meet widely understood benchmarks and which have a good track record showing that they can achieve their goals. Source: The next generation of ETFs, PWC ETF as a disruptor As PWC points out, ETFs have been an important disruptor and it is estimated that they are going to continue to grow at tremendous rates. They have been popular because they are low cost, offer tax efficiency, liquidity, transparency and intra-day pricing. As of August 2013, it is reported that there were 5,000 ETFs and exchange traded products (ETPs) worldwide. This has been threefold increase since the financial crisis. The USA is the biggest market for ETFs, and 70% of global ETF assets are found there. Europe comprises the second biggest market, but has only a quarter of the assets found in the USA are found there. Meanwhile, ETFs are growing extremely rapidly in Asia. One of the most important trends in this area has been the advent of actively managed funds. There have been a number of barriers to this development, but actively managed ETFs account for $13.8 billion in the USA alone. ETFs are not only launching at a very fast rate, but are also closing down very quickly. There were 117 ETF fund closures in the six months to the middle of 2013. It is argued that ETFs are moving from a situation of security selection to asset selection, and this change is especially noticeable in large, liquid markets. Indeed, ETFs in the USA have had a big effect on displacing mutual funds. Popularity has been driven by the ability to produce specific exposure. (click to enlarge) Source: ETFs: $3 Trillion is Nice, but $6 Trillion is Better In the past institutional investors showed a lot of interest in ETFs, but this has been changing to some degree, in regard to how these are seen and used. The reason for institutional investors using ETFs at the outset was for transition management, but at the current time these are viewed as long term holdings, as core allocation vehicles. By 2012, nearly 3,400 institutional investors spread across 50 different countries held ETFs or ETPs, which is double the number that used ETFs seven years ago. In addition to this, 90% of institutional investors are planning to at least maintain, if not increase their level of ETF investments in 2013. Investment advisors and hedge funds comprised 90% of institutional investments in ETFs, with the largest holdings mostly being among large global financial institutions. ETFs have not been a huge success in the retirement market, though it is explained that this is not a big surprise as mutual funds already have low cost share classes that are good for retirement plans. Also the retirement market is not as interested in tax efficiency. Nonetheless it is projected that this sector could grow, particularly in the annuity market. Lower costs are driving this change. Top ETFs for 2016 As suggested by Forbes, the best ETFs to invest in 2016 are as follows: 1. Vanguard Total Stock Market (NYSEARCA: VTI ) 2. Schwab US Broad Market (NYSEARCA: SCHB ) 3. Schwab US Large-Cap (NYSEARCA: SCHX ) 4. Schwab US Small Cap (NYSEARCA: SCHA ) 5. iShares Russel 2000 (NYSEARCA: IWM ) 6. Vanguard Extended Market (NYSEARCA: VXF ) 7. Vanguard FTSE Developed Market (NYSEARCA: VEA ) 8. Vanguard Total International Stock (NASDAQ: VXUS ) 9. iShares Core US Aggregated Bond (NYSEARCA: AGG ) 10. Schwab US Aggregated Bond (NYSEARCA: SCHZ )

Peer Inside The iShares S&P 500 Value ETF

Summary The individual holdings look fairly solid with a heavy exposure to XOM. The sector allocations are going heavy on the financial sector. While those financial firms may benefit from raising short term rates, I’d rather hedge rate risk and add more exposure to utilities. The iShares S&P 500 Value ETF (NYSEARCA: IVE ) is one way to get the value exposure for your portfolio. On the other hand, if you prefer to look at individual sectors you may find the holdings a little more concerning as 25% of the equity is invested in the financial sector. Generally I have tendency to prefer the value side of the index, but going so overweight on financials is an interesting aspect of the fund. Quick Facts The expense ratio is .18%. I have a strong preference for very low expense ratios, so this is a bit higher than I like to see. With over $8 billion in assets under management, it seems better economies of scale could be achieved, but the higher expense ratio may simply reflect more profits to the sponsor of the fund. Holdings I put together the following chart to demonstrate the weight of the top 10 holdings: (click to enlarge) I love seeing Exxon Mobil (NYSE: XOM ) as a top holding. Investors may be concerned about cheap gas being here to stay, but I think money in politics will be around decades (centuries?) longer than cheap gas. Bet against big oil at your own peril. I find the exposure to AT&T (NYSE: T ) interesting simply because the 2.4% weighting is almost twice that of Verizon (NYSE: VZ ). I find the telecommunications sector a little risky because of the intense price based competition brought by Sprint (NYSE: S ). The sector will probably find a solution to the intense competition, but I’ve gotten burned pretty badly by the mining sector where industry competition reached absurd levels and companies opted to focus on lowering their own costs by increasing production and driving down prices. Declining prices for the product combined with increased production and intense capital expenditures is a pretty ugly situation. Outside the Top 10 Outside of the top 10 you’ll find Johnson & Johnson (NYSE: JNJ ) as 1.64% of the portfolio. This is another great dividend company to hold. They have an effective R&D team and a global market presence. Just look at their dividend history and try to come up with a reason that this company shouldn’t be in a dividend growth portfolio: (click to enlarge) Beyond JNJ you’ll also see other dividend champions like Wal-Mart (NYSE: WMT ) and Pepsi (NYSE: PEP ). The heavy exposure to dividend champions is one reason for investors to appreciate the value side of the index. Wal-Mart has been on a massive slide lately but I don’t see it getting much worse before it gets better. The market for equity can be a little too short sighted in valuations. While Wal-Mart is seeing their already thin operating margins get pressed even thinner amid higher wages, they are also the low cost leader. When Wal-Mart raises prices, the rest of the industry should follow. Who will undercut Wal-Mart? Will it be Target (NYSE: TGT )? I doubt Target really wants to do that since they raised wages also and have the same challenge. Sectors Going heavy on financials hasn’t been my style, but increasing interest rates may benefit them more than the rest of the economy. It’ll be interesting to see how much higher the Federal Reserve can push interest rates without crashing the economy. What to Add The biggest weakness here in my opinion is the relatively small position in utilities. Since utilities often have a material correlation with bonds, I’d like to see a little more utility exposure in the portfolio. An investor could modify the exposure by simply adding the Vanguard Utilities ETF (NYSEARCA: VPU ) to their portfolio when using IVE as a substantial holding. Conclusion The expense ratio is a bit high and the concentration in the financial sector is a little higher than I’d like to see. However, the rest of the portfolio exhibits some great traits with a focus on established dividend growth champions that have the size and experience to whether difficult market environments. All things considered, I think there is more to like than to dislike in this portfolio. Some investors with a very long holding period may want to look for options with slightly lower expense ratios. If investors have a shorter time frame or intend to move their positions more frequently the healthy liquidity on IVE should be attractive for creating a smaller bid-ask spread.

Treating The SPDR Dow Jones Industrial Average ETF Like Any Other Investment

Summary The fund holds several dividend champions, but the yield on the index and the ETF are still a bit weak. The sector allocation is fairly aggressive even though the individual companies should be safer than the rest of the sector they represent. Concerns about the strong dollar and rising domestic rates make me prefer a more defensive sector allocation. DIA has an interesting allocation strategy that made a great deal of sense prior to the invention of computers. The SPDR Dow Jones Industrial Average ETF (NYSEARCA: DIA ) is an ETF that is often referenced in stock trackers or in articles referencing the entire economy. However, there seems to be little analysis focused on the real ETF despite having over $10 billion in assets under management. I intend to treat DIA like any other equity ETF in this analysis and look at the fund as an investment rather than as a proxy for parts of the economy. Quick Facts The expense ratio is a mere .17%. That isn’t absurdly high for domestic equity, but it is higher than I would have expected for a very large ETF with a remarkably simple allocation strategy. Holdings I put together the following chart to demonstrate the weight of the top 10 holdings: (click to enlarge) The underlying holdings don’t bother me. 3M (NYSE: MMM ) is a great dividend champion and has an exceptionally diversified product line which includes so many brands and household items that there are probably several items created by 3M within a few feet of you. The portfolio is filled with established dividend champions. Okay, Apple (NASDAQ: AAPL ) won’t be confused with a dividend champion any time soon but for the sheer size of the company it would be strange for DIA to exclude them from the group. Sectors (click to enlarge) The sector exposure feels fairly aggressive to me with the top weightings coming from the industrial sector and consumer discretionary. You may notice that health care and consumer staples each appear to be underweight with utilities coming in at a solid 0%. These are three relatively defensive sectors that I would want to be overweighting when the P/E ratios across the market are getting fairly high. With a strong U.S. Dollar weakening exports and driving down expectations for sales and earnings in the domestic economy and an expectation for higher short term rates coming, it feels like an aggressive sector allocation. On the other hand, if I was going to run such an aggressive sector allocation I would want to be overweighting the companies with a long history and a solid dividend. The individual companies look like some of the safer allocations for their respective sectors. Energy That energy allocation is fairly light. I’ll grant that the sector has done very poorly, but I still like having exposure to the larger companies in the sector like Exxon Mobil (NYSE: XOM ). Exxon Mobil and Chevron (NYSE: CVX ) are the two oil exposures here and I like both of them for the long term despite the potential for more pressure on prices in the short term. Strategy It would be absurd to talk about the ETF directly without bringing up the allocation strategy. The Dow Jones Industrial Average is oldest continuing U.S. market index with over 100 years of index history. It simply holds an equal number of shares in each of the 30 companies within the index. The method is a little strange since many ETFs would simply use a market cap weighting. Instead, the weightings are fairly arbitrary as a function of share prices which results in overweighting anything with a high share price and underweighting anything with a low share price. Dividend Yield If we’re going to contemplate DIA as a normal ETF investment, then it is natural to incorporate the dividend yield. The fund dividend yield is 2.31% while the underlying index has a dividend yield of 2.53%. Conclusion The SPDR Dow Jones Industrial Average ETF tracks the oldest continuing index in the United States. The expense ratio isn’t very high, but it is higher than I would expect for the incredibly simple allocation strategy. The simple strategy, which made great sense prior to computers, results in a fairly interesting sector weighting. I find the underlying companies to be less dangerous than the sectors they represent, but as an investment I would prefer something more defensive sector allocations given my concerns about the potential for the market to suffer some setbacks in a challenging macroeconomic environment.