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FXU: This Utility ETF Is Different From Your Passive Index Funds

Summary FXU has a high expense ratio, high turnover, and limited exposure to individual companies. The ETF includes some companies that I would not immediately think of as traditional utility allocations. Allocations to FXU can reduce portfolio volatility. The strong dividend yield makes it a viable long term holding if investors are convinced management can justify the high expense ratio with superior returns. 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 First Trust Utilities AlphaDEX ETF (NYSEARCA: FXU ). 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 FXU is a hefty .70%, so management needs to be able to beat the sector by a healthy margin over time to provide superior returns to investors relative to lower cost options like the Vanguard Utilities ETF (NYSEARCA: VPU ) which has an expense ratio of only .12%. Holdings I was able to grab a fairly huge chart of the holdings within FXG: (click to enlarge) The first thing I notice in looking at the portfolio allocations is that they are definitely deviating from the indexes I am used to seeing for utility exposure. For instance, Duke Energy Corporation (NYSE: DUK ) is usually one of the largest holdings. VPU uses as the top holding with 7.6% of the portfolio, but FXU has opted to only allocation 3.22% of the portfolio. When it comes to assessing which companies are utilities, I don’t usually think of CenturyLink (NYSE: CTL ) as one of the first options. I would expect it to be in the telecommunications index, but it is interesting to see such a strong allocation here. The interesting thing to note about this portfolio is that it does not use any very heavy weights. I like that aspect of the diversification within the portfolio. When I see a portfolio with extremely concentrated holdings and a high expense ratio, I figure it would make more sense to duplicate the portfolio. Of course, with a high portfolio turnover that is not a viable option. The trailing turnover ratio was around 83%. When investors are paying an expense ratio of .70%, they should be expecting very active management it looks like FXU is certainly delivering in that regard. 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 FXU is an interesting ETF. The exposure is quite materially different from that of the more passive indexes and the individual weightings are lower but the expense ratio is also substantially higher. The fund is considered a utility fund, but they are not afraid to use a small part of the portfolio to go outside of the more traditional utility allocations. Despite a very high turnover ratio, the ETF is still offering a very solid dividend yield. If investors want active management of the allocations within the ETF, FXU is a reasonable allocation. Personally, I have a preference for taking the lower expense ratio and the more passive indexing approach for my long term allocations. Make no mistake; FXU is not a short term allocation. A heavy dividend yield around 3.7% is enough to ensure investors are receiving income from their investment so they can reasonably hold the shares over the long term and utilize the income from dividends for either growing the position or covering living expenses. From a portfolio perspective the ETF is offering a fairly nice low beta of .67 and has maintained a negative correlation with treasury ETFs despite both being influenced by movements in interest rates.

How Do Fund Flows Affect Fund Performance?

A study by Morningstar acknowledges that the relationship between fund flow (or investors’ purchases and redemptions of mutual funds) and fund performance may be stronger than previously considered. However, the study based on three-year performance of stock-picking funds between 2006 and 2014 revealed that funds with high inflows, stood a lower chance of outperforming peers. Large-cap funds attracting most inflows had an average return of 7.8%. This compares unfavorably with funds with biggest outflows offering an average return of 8.1%. In many cases, outperformers tend to attract inflows. The strong rally may have run its course, leading to the tepid performance of those high inflow funds. Also, funds with massive inflows will have to employ the cash; otherwise the cash in net assets may swell and thus affect the fund’s allocation style. The positive on the other hand is that increased cash can help fund managers invest them in new stocks or financial instruments, without selling the existing portfolio. This in turn keeps the turnover ratio low. (To learn more about turnover ratio, click Does Turnover Ratio Influence Mutual Funds? ) Thus, fund flows may have an impact, but not necessarily in all cases. This is better explained in Pimco’s legal disclosures to the PIMCO Total Return Fund (MUTF: PTTAX ) investors. It says purchases or redemptions “may cause funds to make investment decisions at inopportune times or prices or miss attractive investment opportunities. Such transactions may also increase a fund’s transaction costs, accelerate the realization of taxable income if sales of securities resulted in gains, or otherwise cause a fund to perform differently than intended. While such risks may apply to funds of any size, such risks are heightened in funds with fewer assets under management.” Fund Category Performance with Highest Inflow & Outflow in August This year, the bleeding continues for funds and particularly for active funds. According to Morningstar data, open-end mutual funds saw outflows of $31.9 billion in August. Interestingly, not all fund categories that saw the largest outflows in August were in the red for August. Similarly, inflows did not necessarily mean that funds ended up in positive territory. Except for Europe stock funds, five fund categories that had the highest August inflows have posted year-to-date losses. In August, all these five categories finished in the negative zone. The magnitude of losses in August for categories with highest inflows was significantly larger than those categories that saw largest outflows. Categories with Highest Inflows in August ($ in Million) Total Return (%) August YTD August YTD Foreign Large Blend 11880 80302 -7.1 -0.8 Multi-alternative 1464 11145 -2.3 -1.3 Managed Futures 1122 6220 -2.7 -1.5 Global Real Estate 982 1644 -5.7 -4.5 Europe Stock 943 4218 -6.1 2.5 Categories with Highest Outflows in August ($ in Million) Total Return (%) August YTD August YTD Intermediate – Term Bond -6711 29175 -0.4 0.1 Large Value -3866 -22052 -6 -5.3 Multisector Bond -3484 1920 -1.1 -0.4 Large Growth -3337 -26518 -6.4 0.3 World Bond -3116 13711 -0.9 -3.1 Source: Morningstar Top & Bottom-Flowing Active Funds Below we present the list of top and bottom flowing active funds for August: Top Flowing Active Funds Net Inflow ($ in million) Performance (%) Aug-15 1 Year Aug-15 1 Year DoubleLine Total Return Bond Fund (MUTF: DBLTX ) 965 12245 -0.3 -1 PIMCO Income Fund (MUTF: PONAX ) 750 10659 -1.2 -4.2 Strategic Advisers Core Fund (MUTF: FCSAX ) 743 2549 -4.8 -5 Brown Advisory WMC Strategic European Equity Fund (MUTF: BIAHX ) 680 725 -6.6 -3 T. Rowe Price Emerging Markets Stock ( PRMSX) 649 1940 -9 -20 As we can see, all these top flowing active funds had ended in the red for August and also over the last 1-year period. The reason is not necessarily the inflows, but as we know August has been a cruel month for the broader markets. However, once we compare the performance of active funds that had the biggest outflows, we will see that their loss was much larger. This is in contrast to the trend we noticed for the fund categories in August; where categories with largest outflows suffered relatively less losses. Bottom Flowing Active Funds Net Outflow ($ in million) Performance (%) Aug-15 1 Year Aug-15 1 Year GMO Asset Allocation Bond (MUTF: GABFX ) -2,018 -1,902 -0.6 -11.3 PIMCO Total Return (MUTF: PTTRX ) -2,015 -124,484 -1.1 -4 Templeton Global Bond (MUTF: TPINX ) -1,922 -6,013 -5.4 -14 Franklin Income Fund (MUTF: FKINX ) -1,473 -3,035 -4.4 -14.8 Oppenheimer Developing Markets (MUTF: ODMAX ) -1,059 -1,824 -10.6 -27 Source: Inflow/Outflow data from Morningstar; Performance data calculated using GoogleFinance. For the first time since Bill Gross quit PIMCO to join Janus , the PIMCO Total Return Fund was not at the bottom of funds with the most outflow. It took up the second seat instead. Its 1-year net outflow leads the pack, but the loss is not as much as others. PTTAX has lost 4% over the 1- year period, whereas the others including the Oppenheimer Developing Markets Fund, the Franklin Income Fund, the Templeton Global Bond Fund and the GMO Asset Allocation Bond Fund have suffered larger losses. Coming to Zacks Mutual Fund Ranks, the DoubleLine Total Return Bond Fund, the PIMCO Income Fund and the Templeton Global Bond are the only ones that currently carry a favorable rank. While DBLTX carries a Zacks Mutual Fund Rank #1 (Strong Buy) , the latter two carry Zacks Mutual Fund Rank #2 (Buy). The Strategic Advisers Core Fund and the PIMCO Total Return Fund have a Zacks Mutual Fund Rank #3 (Hold). Meanwhile, the T. Rowe Price Emerging Markets Stock Fund and the GMO Asset Allocation Bond Fund hold a Zacks Mutual Fund Rank #4 (Sell) and the Franklin Income Fund and the Oppenheimer Developing Markets Fund carry Zacks Mutual Fund Rank #5 (Strong Sell). As said, in certain cases there is more arts than science. Fund flows may be just a fraction of a factor to help a fund’s uptrend. Inflows may not translate into gains for mutual funds. Investors do not necessarily have to buy funds that are seeing strong inflows and vice versa. Link to the original post on Zacks.com

The Dividend Discount Model And You: Proper Use And Limitations

Summary The dividend discount model is a simple valuation model for dividend investors to use in valuation. Like all models, it is only as good as the inputs used. Regardless of its drawbacks, the use of models forces investors to forecast company results and evaluate their own risk tolerance, which can only be positive for investor returns and contentment. Valuation can be a tricky subject for investors managing their own portfolios. As investors, we might like a particular company, its business, and its future prospects. But what exactly is a fair price to pay? Sure, we can look at valuation measures like P/E and EV/EBITDA and compare those numbers against historical values, but then we are just speculating that the company will return to its long-run average. Is there a better way? Financial models can be one answer to that problem. Novice investors usually start with the dividend discount model. The dividend discount model is an extremely simple, conservative valuation technique for evaluating dividend-paying stocks. While every model has its weaknesses, I believe that at the bare minimum, applying the dividend discount model to your holdings encourages you to think about, understand, and then model your portfolio holdings. Understanding the application and foundations of the dividend discount model is fairly simple. It fits into the broad bucket of discounted cash flow analysis. What we are trying to accomplish when using the model is to put a value on what a company’s future dividend cash flow is worth to us in today’s money. When we talk about “discounting” those future cash flows, we’re adjusting those numbers to reflect its value today. For example, because of the time value of money, a payout of $1,000 one year from now is worth less than $1,000 to you today. Money today has the ability to earn returns and avoid inflation, something that money in the future cannot claim. The median point where we are ambivalent between two amounts of money at different times can help us calculate our required rate of return, along with evaluating the riskiness of holding a particular stock we are analyzing. So, if our required rate of return is 8%, the discounted value of $1,000 one year from now is $925.93 ($925.93 * 1.08 = $1,000). The Basic Formula (click to enlarge) What you’ll notice from the formula is that it assumes a constant dividend growth rate. We all know dividend growth rates vary from year to year, but in the best case for modeling, we attempt to use what the long-run average will be. The weakness here as well is that the greater the dividend growth, the more minor differences between your hypothesized growth and real-world results can skew our model. So this simplistic model works best for securities with lower dividend growth rates and stable earnings. For income investors, using this model for utilities stocks should spring to mind quickly. Real-World Application Example Below, we have an example of ALLETE (NYSE: ALE ), a utility that generates energy for customers in Wisconsin, Michigan, and other surrounding states. It currently trade at $48.55/share. I’ve written a fairly pessimistic article on ALLETE , but we can see if the results from the dividend discount model back or disprove my thesis, based on various inputs. ALLETE currently yields $2.02/share annually, and has grown its dividend at an average 2.2% annual rate for the past five years, so we’ll use those numbers to run our valuation, along with an 8% required rate of return. We will assume the dividend will be $2.12 next year. P = 2.12 / (.08 – .022) P = 2.12 / 0.058 P = $36.55/share Based on this valuation, we come to a fair value of $36.55/share, or roughly 25% below current prices. To show how the model can be sensitive, let us instead change our assumptions. Perhaps based on our research, we find that going forward, management will be able to raise the dividend 3.25% annually instead of 2.2%, because maybe we have found information that has led us to believe the utility will be allowed a higher rate of return by its regulators. Additionally, we find that our own required rate of return is only 7% for ALLETE, because the stock has less financial risk than we previously thought. P = 2.12 / (.07 – .0325) P = 2.12 / 0.0375 P = $56.53/share Our calculated fair value per share is now $56.53, or more than 15% above current prices. Which is correct? That depends, based on your analysis of management’s ability to continue to raise dividends into the future and your own assumptions on the riskiness of the holding, which factor into your required rate of return. Multi-Step Models What if we think the dividend will grow at 3.5% for the next five years for ALLETE, and then 2.25%, after using an 8% required rate of return? The dividend discount model can be adapted to be used for multiple stages of growth to suit the reviewer’s needs. Year One Dividend = $2.12 * 1.035 = $2.23 Year Two Dividend = $2.23 * 1.035 = $2.31 Year Three Dividend = $2.31 * 1.035 = $2.39 Year Four Dividend = $2.39 * 1.035 = $2.47 Year Five Dividend = $2.47 * 1.035 = $2.56 Year Six Dividend = $2.56 * 1.025 = $2.62 Once we have the values, we can then discount those to their net present value: $2.23 / (1.08) = $2.06 $2.31 / (1.08) 2 = $1.98 $2.39 / (1.08) 3 = $1.90 $2.47 / (1.08) 4 = $1.82 $2.56 / (1.08) 5 = $1.74 We can then apply the constant growth model we used previously to determine their value, based on the fifth-year dividend value: P = 2.62 / (.08 – .0225) P = 2.62 / 0.0575 P = $45.57/share This value has to be discounted to net present value as well. P = 45.57 / (1.08) 6 P = 45.57 / 1.5868 P = $28.72 Add up the values of the five higher-growth dividends with your constant growth value: P = 2.06 + 1.98 + 1.90 + 1.82 + 1.74 +1.65 + 28.72 P = $39.87/share Conclusion Like any and all financial models, the dividend discount model is sensitive to the inputs used to value the security. Thus, financial modeling isn’t the grand answer to record-beating returns, and I wouldn’t advocate for retail investors to bury themselves in Excel spreadsheet models. However, financial modeling can force investors to think about issues that are extremely important to the stock valuation process, which can drive critical re-evaluations of your positions based on your own inputs and expectations. 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.