Tag Archives: income

CenterPoint Energy: Consider This High Yield, Low Growth Utility

Summary I’ve written about several utility companies lately. They varied in growth and dividend yield. In one article, I said Southern Company should be avoided at the moment. In this article, I will write about investing in CenterPoint Energy, which I believe is a superior high yield, low growth utility. Introduction As I’ve written in several of my articles, I usually divide my dividend growth stocks in two ways. The first is by sector, which helps me diversify my portfolio. The second is by the state of the company. I then divide the companies into three types. The first is companies with low yield and high growth, the second is medium yield and medium growth, and the third is high yield and low growth. Sometimes you can find some bargains and get a high growth company for medium or even high yield, but usually the market knows how to price stocks. I’ve written about several utilities lately. These utilities were divided between these three groups. I wrote about ITC holdings (NYSE: ITC ) which has low yield and high growth; Wisconsin Energy (NYSE: WEC ) — my personal favorite — which has medium growth and medium yield; and Southern Company (NYSE: SO ), which has high yield and low growth. I also wrote in March about Avista (NYSE: AVA ), which also shows medium growth and medium yield. Retirees and older people look for the current yield, and therefore agree to accept the extremely low growth shown by some companies. In this article, I will analyze CenterPoint Energy (NYSE: CNP ), a company that has a higher yield than Southern Company and similar low growth. In my opinion, this company is more suitable for investors looking for current income. CenterPoint Energy is a public utility holding company. Through its subsidiaries it is engaged in the following business segments: Electric Transmission & Distribution, Natural Gas Distribution, Competitive Natural Gas Sales and Services and Other Operations. Fundamentals When I look at the past decade, CNP’s fundamentals seem pretty strong. However, as I will show here, they are not going to grow at the same pace in the future. For example, revenue actually declined from $9.7 billion in 2005 to $9.2 billion in 2014. This is an annual decline of 0.5% for the past decade. In the near future, both the company and analysts covering it believe that revenue will grow due to rate relief from the regulators as well as the growing number of customers. CNP Revenue (Annual) data by YCharts On the other hand, EPS has managed to show some significant growth. EPS grew from $0.75 in 2005 to $1.42 in 2014, which is a CAGR of over 6.5%. This is a decent number for a utility. However, the EPS for 2015 and 2016 will be much lower. The estimates for 2015 are between $1.05 and $1.1, and the company has reaffirmed its guidance for 4%-6% annual growth in EPS for 2015-2016. Basically we have a company that will probably show modest growth in both revenue and EPS for the next 3-5 years. CNP EPS Diluted (Annual) data by YCharts The dividend is probably the biggest reason to purchase this stock, as the EPS will grow slowly. The dividend has been raised every year over the past decade, and it grew from $0.38 in 2005 to $0.96 in 2014. This is a CAGR of almost 10%, which is much higher than the EPS growth. Due to that fact, the current payout ratio is 70% for the 2014 earnings, and over 90% for the mid point of the 2015 EPS guidance. Therefore, I believe that the future growth will be limited to less than the EPS growth, and I believe it will be in the range of 2.5%-4%. However, as the company is a utility, which is a regulated monopoly, the dividend is still sustainable. The current yield is really robust at 5.8%. CNP Dividend data by YCharts When I look at the fundamentals, I find that the growth will be slower in the future, but the yield is high enough to compensate income-oriented investors. I find it more attractive than Southern Company as the yield is higher, but the growth estimates are not lower. Valuation Valuation at the current price is pretty compelling, especially when compared to its peers. Due to the low growth, the company trades for a lower P/E than Wisconsin Energy or Avista. Their premium is explained by the higher growth. Currently, CNP trades for a P/E ratio of 15.62 for 2016, and 15.19 for 2017. This valuation is fair for a slowly growing company. CNP P/E Ratio (Forward 1y) data by YCharts In these two graphs, I compared the P/E ratio of CNP to the P/E ratio of SO. I made this comparison because both are diversified utilities that work in the southern part of the U.S. Both have high yield and low dividend growth going into the future. CNP has a much higher yield, and still the P/E is almost the same. I believe it is more attractive than Southern Company. Opportunities Regulation of utility companies can be an opportunity or a risk. At the moment, CNP states that current regulations are favorable to its ability to generate profits. In addition, in the past several months the company has asked for rate relief in a number of states, and regulators granted many of them. In the table below, you can see some of the granted requests. Some are still under examination by regulators, and will be determined shortly. This relief allows the company to increase its revenue and margins. The rate relief accounts for almost $300 million annually, and I believe it alone can push up revenue by 2% before inflation. This way, we can achieve growth of 3%-4% just by increasing the prices annually, and over 50% of it will come from the rate relief. Together with cost cutting efforts, the rate relief will not only increase revenues, but also profit margins and EPS. The goal is to reach double-digit profit margins, and it will take more price increases, as the current profit margin is almost zero. Another opportunity the company’s business segment and geographic diversification. It operates in several states, which means it has no exposure to a single regulator, diminishing its regulatory risk and giving it an advantage over its peers in that regard. Its revenues are divided equally between three segments: electric transmission, gas distribution and energy services. In addition, the company is a major holder of Enable Midstream Partners (NYSE: ENBL ), a joint venture with two of its peers — GE Energy and ArcLight Capital Partners. The entity is considered an MLP. It’s relatively not leveraged and has several growth prospects. It is a great opportunity for CNP to keep growing. When energy prices recover, MLPs’ prices will rise along with their profitability. This offers potential upside for CNP investors as an energy recovery play. When I said that Wisconsin Energy is a better investment than Southern Company, I was told to look at the area where the companies operate. WEC is in the rust belt, while SO is in the growing south. CNP operates mainly in the growing south, just like SO. Its primary customers are in the area around Houston, Texas, and the company dedicated an entire slide in its Q3 presentation to show that it operates in a quickly growing area. This gives CNP the ability to grow organically in the future. Houston is a huge opportunity for many reasons. First, it is one of the fastest-growing cities in the U.S., according to Forbes. Moreover, according to the Texas State Demographer, Houston’s population is set to keep growing in the next 35 years, mainly due to immigration. Houston is a great opportunity, as it is much more than the center of energy companies it used to be. Over 1500 corporations have relocated to Houston over the last 5 years, and it is becoming a base for medical companies and financial companies as well. All of these people and businesses will need both electricity and gas, and CNP will supply it. Risks The company still presents risks for investors. The first is its balance sheet. CNP is using a lot of debt. I believe that the debt load is manageable, and the company is aware of the associated risk. However, imminent interest rate hikes will make this debt more expensive. I must add that although any rise in interest rates is forecast to be slow, at CNP’s current debt to equity ratio, which is higher than 2, its fragile A1 credit rating may still be in jeopardy. CNP’s cash on hand decreased by almost 30% this year, and the credit rating agencies warned that its narrowing liquidity puts its credit rating at risk. When interest rates rise, more expensive debt may put this leveraged company in a very uncomfortable position, which will force it to cut the dividend. The company should maintain more than $100 million in cash, and it currently has around $225 million. The company is forecast to show very modest EPS growth in the medium term. This can easily mean a dividend freeze, and at the current dividend payout ratio, it will be very hard for the company to raise its distribution. In addition, the favorable regulatory environment mentioned above can always change. One regulatory change by a major state or by the federal government can result in damage to CNP’s income. With a payout ratio of 92%, that may cause a dividend cut. However, this risk is not too great, as the southern states where CNP operates tend to have favorable regulation for enterprises. The company should be very cautious in the short term to make sure that its dividend is sustainable. The combination of the growing dividend with rising interest rates and the current payout ratio could become a problem if management isn’t careful. The company does not produce electricity. It allows the producers to use its infrastructure to deliver electricity to its customers. These companies can create their own transmission network or use a competitor’s transmission network if they feel CNP’s prices are too high. However, this risk is mitigated by the fact the infrastructure request a lot of capital invested, which gives CNP a bit of a moat. Conclusion CNP is currently a solid business. It has almost no room for error in the medium term, but can still offer a better income than its peers. Of course, a dividend freeze is a very real concern if the company cannot grow EPS at the pace of the guidance. However, the MLP business can offer interesting upside in the future. At 25 years old, an investment that grows pretty slowly is not for me. I try to look for dividend growth stocks that can show medium to high growth, even if it comes at the expense of current income. Retirees and older investors should consider CNP, however, as its 5.8% yield is quite attractive for current income seekers.

Changes Coming For Guggenheim Large-Cap ETFs

Summary This is the first in a series of (free-standing) articles analyzing the 121 large-cap ETFs that are currently available. Guggenheim currently has five large-cap ETFs, although one will be closed in January and another will be changing its index provider. I rank the five ETFs and come to some interesting conclusions about which of Guggenheim’s funds seems to be the best. In one of my recent articles, 1 I mentioned that a serious all-ETF portfolio needed to have at least one fund focused on U.S. large-caps. Which one? As of this writing, there are 121 ETFs that direct their attention to large-cap holdings, many focusing on the S&P 500 , the Russell 1000 or any of the variants of those two basic indices. 2 Is there a fund that could be said to be, in some meaningful sense, better than the others? Or, at least, is there some identifiable group of funds that seems to be – again, in some sense – better, from amongst which one could choose with a bit of confidence? I propose to do a long-term project involving the comparison of large-cap ETFs. My goal will be to identify funds that have promise, while at the same time identifying funds that might not be as tempting as others. Each article will be restricted to a handful of funds that have something in common (issuer, index, methodology, weighting, etc.); over the course of the project, no doubt some funds will show up more than once. In the end, it is not my expectation that there be one special fund that I hold up as the ” winner ,” but that readers will have some cogent discussions that may help separate the wheat from the chaff. Hopefully, there will be some surprises along the way just to keep things interesting. Along the way, I hope to develop some tools that will help in examining the group of large caps, and possibly help shed some light on other classes of funds, as well. 3 The articles are intended, and expected, to be independent from one another, so readers need not feel that they have to commit to the whole series. 4 The Guggenheim Large-Cap Funds Guggenheim Funds Distributors, LLC currently offers five ETFs that focus on U.S. large caps: Guggenheim Russell 1000 Equal Weight ETF (NYSEARCA: EWRI ) Guggenheim S&P Equal Weight ETF (NYSEARCA: RSP ) Guggenheim S&P 500 Pure Growth ETF (NYSEARCA: RPG ) Guggenheim S&P 500 Pure Value ETF (NYSEARCA: RPV ) Guggenheim Russell Top 50 ETF (NYSEARCA: XLG ) A couple of changes are in the works for two of the funds and will be discussed in due course. Below is a brief description of each fund. EWRI is one of the two Guggenheim ETFs that will face changes on January 27, 2016: this fund will effectively cease to exist , its portfolio will be merged with RSP . Guggenheim’s reason for the merger is that the Russell 1000 is not a pure large-cap index , but includes a substantial number of mid caps, as well. As a result, EWRI – which is intended to be a large-cap fund – overlaps with Guggenheim’s mid-cap ETF and is considered by Morningstar to be a mid-cap blend. 5 According to Guggenheim, after the change, the company’s large-cap, mid-cap and small-cap funds will be distinct and have no overlaps. 6 Guggenheim asserts that the S&P 500 , S&P 400 and S&P 600 indices unambiguously and without overlap cover the large-cap, mid-cap and small-cap stocks, respectively. Finally, RSP has outperformed EWRI , and its smaller portfolio (500 holdings as opposed to EWRI’s 1,930 – now down to 1,023) is more efficient and more easily managed. 7 The transition will involve the flow of EWRI assets to RSP in exchange for shares of RSP ; the accumulated shares of RSP will then be distributed to EWRI shareholders on a pro rata basis, with fractional shares being distributed as cash. 8 Guggenheim expects that there should be no tax liability for shareholders. 9 The fund would seem to be going through some transition pains. Based on its current NAV and ER, compared to its 2014 expenses, it has an expense efficiency 10 rating of 126.48% – too high for a fund with only $71.19 million in assets , 11 and the merger is certain to impose more costs before the fund closes. The fund’s slight assets do provide it with a higher RoNAV . 12 When RSP’s merger with EWRI is finished, the result should not have that much bearing on this prominent ETF. EWRI ‘s assets amount to less than 1% of RSP ‘s, and ultimately they should end up simply increasing the number of shares RSP has of each of its holdings – and that , by only a small margin. I have to confess that I do like this fund – primarily for the fact that it is equal-weighted and has a tendency to outperform funds that are based on the standard S&P 500 , cap-weighted, index. I have come to think of it as my “go-to” fund when I want something to use as a comparison, or when I want to test an ETF-only investment portfolio. 13 RSP offers a nice, if unremarkable yield; as we will see below, its strong suit tends to be its performance. The fund’s managers seem to be keeping the expenses down, resulting in an EER of just under 75% – taking some of the edge off the 0.40% expense ratio. Until I get a better feel for the significance of RoNAV , I will just point out that it’s 1.11% and is towards the low end for the Guggenheim funds. 14 RPG manages to present some of the better numbers of any of the Guggenheim funds, but does so while also putting up some of the more unfortunate numbers of the group. The fund’s portfolio is made up of those in the S&P 500 that show the greatest growth potential, as determined by Standard & Poor’s . Currently, the index lists 106 companies as having “strong growth characteristics.” The fund had a 46% turnover rate for its most recent fiscal year – which is described as “average.” 15 RPG ‘s expense efficiency is very nice – only 54.50% of anticipated expenses. It does have a very low yield – not the fund to turn to if you want dividend income. The lower income also results in a low return on NAV – the lowest of the five funds presented here. RPV ‘s index consists of 123 constituents of the S&P 500 that are deemed by Standard & Poor’s to have strong characteristics regarding value. RPV is perhaps the polar opposite of its sibling, RPG . Where RPG has an extremely nice EER, RPV sports one of 103.64% – over the 100% line. On the other hand, it has the highest yield of the five funds and one of the highest RoNAV of the group. The value portfolio had a turnover rate of 25%. XLG is based on the index of the 50 largest companies (by market capitalization) in the Russell 3000 index ; ETF.com calls it “the ETF for investors who don’t want to hold any companies they haven’t heard of.” 16 The fund is the second of Guggenheim’s large-cap funds that will undergo a change on January 27, 2016; on that date, XLG will have its index changed to the S&P 500 Top 50 Index . The change, according to the issuer, is intended to maintain continuity among its funds, particularly those following S&P-based indices. There should be nominal change in the holdings of XLG (which will retain its ticker, but be renamed the Guggenheim S&P Top 50 ETF ), as it currently appears to have 48 holdings in common with the 50 S&P components having the largest market caps. 17 XLG seems to excel in most measures: it has an expense margin of 91.24% , its expense efficiency is better than 94% (along with a low 0.20% ER ), its RoNAV is a group-best 1.97% , and it has a handsome 2.06% yield. Comparative Performances So, how do they actually stack up? The following chart illustrates the performance of each of the funds since their inceptions: (click to enlarge) As the key to the chart shows, looks can be deceiving. XLG would seem to be outperforming the other four, but – since its inception in 2003 – RSP has increased by 208.81% , outperforming the other four funds, with XLG actually trailing the pack with only 62.72% increase in value. 18 Of course, measuring the funds since their inceptions is misleading, as well; RSP has a two-year advantage over XLG , and a nearly three-year advantage over RPG and RPV (and a seven -year advantage over the doomed EWRI ). The following chart shows performance from the inception date for RPV and RPG : (click to enlarge) Since March 3, 2006, the growth-oriented RPG surpasses RSP by an impressive 6,000 bps – and, again, XLG trails the others. 19 The Recession After looking at both of the above charts, I was intrigued by how the funds performed during the “Great Recession”: all of the funds hit recession-period bottoms on Monday, March 9, 2009 (although, actually, RPV hit its low on the previous Friday, March 6). By all appearances, XLG took a huge tumble, compared to the other funds. How did the funds take the recession? The following chart illustrates: (click to enlarge) Interestingly, RSP and RPV hit their pre-recession highs on June 4, 2007 ($52.67 and $37.40, respectively), while RPG and XLG hit their highs on October 10 ($39.79 and $117.32, respectively). 20 In terms of percentage, both RPG and XLG suffered the least, both losing less than 54%; RSP was about 700 bps behind, at just under 61%, while RPV lost the most, dropping more than 76%. It took 17-20 months for the funds to give up their losses; recovery, for the most part, took a lot longer. RPG surpassed its pre-recession high on October 25, 2010 – 19 months after hitting bottom. RSP would take nearly two more years before reaching a new high of $52.69 on September 12, 2012. RPV would follow in six months , hitting $37.54 in March, 2013, and XLG would reach $117.63 two months later . What I find interesting here is that these funds are all drawn from the same well: the S&P 500 . RPG , RPV , and XLG are all proper subsets of RSP , which is itself a subset of the S&P 500. The S&P reached its pre-recession high of 1565.15 on October 9, 2007 – the day before RPG and XLG reached theirs. The lowest close for the S&P during the recession was 676.83 on March 9, 2009 – the same day as the Guggenheims – for a drop of 57.76%, which places it right in the middle of the Guggenheim funds. This can give us a little insight into a few things: First , RSP lost more value during the recession than either RPG and XLG presumably because RSP has significantly more smaller-capped companies. How do we come to that conclusion? Because RSP underperformed the S&P 500, even though the two would be (in principle) co-extensive, the only difference being that the S&P is cap weighted, while RSP is equal weighted. Being equal weighted, RSP places greater weight on the smaller-capped holdings than does the S&P; thus, if RSP underperforms the S&P, it would be reasonable to assume that the principle cause was the extra weight given the smaller-capped companies. Second , if smaller large-cap companies bore significant losses during the recession, we can assume that the reason for RPV’s performance during this period would be due to a larger number of smaller-capped holdings. This only goes so far as an explanation, in that there is an overlap between these funds: RPG and XLG have 17 funds in common, while RPV and XLG have eight in common (meaning some of the mega-caps are, according to S&P’s formulary, still values). 21 Third , Standard & Poor’s formula for determining growth stock seems to be spot on, as RPG recovered from the recession quicker than the other three funds, and did so by a substantial margin. I take it by “growth” they mean “quick growth” – sprinkle some Miracle-Gro on them. The 2010 “Correction” Given the performances of these funds during the recession, I thought it might be interesting to see how they fared during the recent “correction” the market experienced recently. The following chart gives an indication: (click to enlarge) The chart shows fund performances for the period from June 1, 2015 through November 20, 2015 (the prices on the far left and far right of the chart). It also shows the highest point and lowest point for each fund (the dated prices) – with all highs coming before August 25, the day “the bottom dropped out.” All four ETFs lost more than 10% of share value from their respective highs, with RPV losing the most at 15.79%. For the period illustrated, only one fund – XLG – has shown a gain in share price overall. Needless to say, none of the funds had surpassed their high points for the period. 22 Compound Annual Growth Rate (CAGR) One last consideration ought to be made before trying to “judge” these funds: what one gets from them. The following chart shows returns based on historical prices adjusted to accommodate splits and dividends: (click to enlarge) When we take into account dividends, and particularly when we look at share performance since March 9, 2009, RPV shows a measure of life it hasn’t shown thus far. The value fund’s group-leading yield pushes its fairly modest performance in all other measured data to a post-recession growth of 552.34% , outperforming nearest contender RPG by 213 percentage points. Another way of quantifying the returns realized by these funds is through their CAGR s. The following graph shows the CAGRs for each fund (including EWRI ) computed both from date of inception ( CAGR-I ) and for the five-year interval from November 20, 2010 to 2015 ( CAGR-10 ): (click to enlarge) Head-to-head over the past five years, RPV has markedly outperformed the other funds – again, largely due to its dividend yield. Of course, CAGR data can be misleading, in that it the annual returns each fund would provide as if growth was a constant , which it is not. Nevertheless, however, it is an effective way to illustrate the total returns one might expect from a holding. As illustrated above, moreover, it can show that all of the funds have realized a greater rate of growth in the past five years than is historically the case. Assessment I have to confess that I still have not worked out a way of rating the funds in some way that would be meaningful once all 121 ETFs are put together. For the time being, I am simply weighing each component of the analysis, 23 with each component bearing an equal weight – essentially, scoring is based on ordering for each component. I am trying to keep it simple, in the absence of something cogently complex. Of the five funds considered here, XLG comes out on top, with RPV just nominally behind – and this pretty much sums up two prominent approaches to investing: for growth/security [ XLG ] or for income [ RPV ]. I must confess to being slightly surprised that RPV ended up scoring as high as it did – this may be something of a sleeper. RSP and RPG tied for third place, each one showing its strengths in line with RPV and XLG , respectively. RSP was stronger on the income -based factors, while RPG was stronger in the growth elements. I am somewhat disappointed in how RSP fared. 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 the 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 Yahoo! Finance. Data from any other sources (if used) are 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 ” QLC: Large-Cap ETF With High-Quality Stocks .” 2 Not counting ETNs (of which there are about six) or leveraged/inverse funds (of which there are ~ 27). 3 I have discussed one such tool already, when I introduced “expense margins.” As I prepared this article I came across two more: return on NAV ( RoNAV ) and expense efficiency rating ( EER ). RoNAV has appeared in a few of my recent articles, and reflects the relationship between NAV and the net income generated therefrom. EER is meant to capture the difference between the expenses actually paid in a fund and the expense ratio on which many investors place great weight. A discussion of what these data represent – and how they are determined – can be found in my blog . 4 Of course, I will not discourage you from reading all of the articles if your tolerance for boredom is sufficiently high. 5 The Guggenheim Russell MidCap Equal Weight ETF (NYSEARCA: EWRM ). EWRM will change index to the S&P MidCap 400 index on January 27, and will become the Guggenheim S&P MidCap 400 Equal Weight ETF (EWMC). 6 Transition of Guggenheim ETFs to S&P Dow Jones Indices, a list of key considerations and FAQs. The Guggenheim Russell 2000 Equal Weight ETF (NYSEARCA: EWRS ) will become the Guggenheim S&P SmallCap 600 Equal Weight ETF (EWSC). Available here . 7 ETF.com adds some additional considerations to the reasons for the merger: 1) EWRI has not traded well, with only an approximately $216,410.00 in average daily volume (compared to RSP ‘s $64.14 million average); 2) on December 23, 2014, PowerShares issued an ETF identical to EWRI – the PowerShares Russell 1000 Equal Weight ETF (NYSEARCA: EQAL ). Implied – there’s not enough market for the ETFs to support two funds. 8 Per ETF.com . 9 Guggenheim FAQs, note 4, above. 10 See EER in note 2, above. 11 An EER > 1 means that it is spending more on expenses than “anticipated” in its expense ratio. 12 See RoNAV in note 2, above. 13 I gave the fund a thorough going-over in ” Guggenheim s RSP: Equal Weight Or Dead Weight? ” I used it for comparison purposes in the QLC article mentioned above, and as a component for a trial portfolio in ” Brown s Permanent Portfolio Vs. Porter s ETF Retirement Portfolio .” 14 Of course, as with any figure related to returns, higher is usually going to be better, but I do not expect to have a clear indication of what sort of RoNAV to expect from large-cap ETFs until I have gotten further through the project. 15 Guggenheim ETFs Prospectus, p. 6. 16 ETF.com . 17 The index itself does not appear to be available yet, and I based the comparison on a list of the top 50 S&P 500 companies generated in finviz.com . 18 On April 27, 2006, RSP underwent a 4-for-1 split. I have adjusted the prices prior to the split to reflect one-fourth of their actual value. 19 I have dropped EWRI from this and subsequent charts because: a) its performance has not been that impressive, and anyway, b) it will cease to exist in less than two months. 20 All prices are closing prices as of the day cited. 21 There are no overlaps between RPV and RPG , and this is why they are considered “pure” – the formula that determines if a holding is a value stock excludes the possibility of a growth stock being included, and vice versa. Since no specific formula is needed (in principle) to determine which stocks have the largest market capitalization, there is no consideration given to “value” or “growth” conditions. 22 XLG did come close on November 3, when its price closed at $148.31 – missing the high by $0.46. 23 Expense margin, expense ratio, expense efficiency rating, return on NAV, yield, and the two CAGRs. I am also considering counting the recovery period from recession and some meaningful assessment for performance over the recent correction.

Alternatives For The Future

The article first appeared in the December issue of REP . magazine and online at WealthManagement.com Along with other Yuletide treats, some Yanks are now anticipating the gift of a Fed rate hike. Better-than-expected employment numbers, an uptick in the manufacturing sector and pickup in wages have given the U.S. central bank the backstory for normalizing the nation’s monetary policy. The odds of a rate step-up, implied by Federal Funds futures, shot up from 7 percent to 70 percent in November. Simultaneously, expectations pushed the Treasury long bond yield up nearly a quarter of a point, effectively discounting the Fed’s anticipated action. Now that the markets have priced in the first Fed rate hike, it’s debatable whether it will be “one-and-done,” or the first step along a steady path of snugging. Either way, the die is cast: Rates are bound to rise, and sooner rather than later. With the coming of the end of the zero-rate environment, investors and advisors must rethink their portfolio strategies, most especially their alternative investment allocations. The basic question facing them now is which exposures are most likely to continue providing risk diversification in a rising rate environment. To answer that question, let’s look back at the liquid alt universe over the past five years and gauge each category’s correlation to a fixed income market proxy, the iShares Core Total U.S. Bond Market ETF (NYSEARCA: AGG ). AGG tracks an index of investment grade notes and bonds including Treasuries, agencies and corporates as well as mortgage- and asset-backed paper, all with a weighted average maturity just under 13 years. Currently, AGG offers a 2.4 percent distribution yield. Two Things An ideal diversifier should be negatively correlated to AGG. Thus, when rates rise (and AGG’s price, as a consequence, falls), the alternative investment should appreciate. There are five categories that are negatively correlated to AGG: arbitrage, hedged equity, commodities, long/short equity and market-neutral. Based on the foregoing criterion alone, the arbitrage category seems to have the best track record over the past five years. Keep in mind two things, though. First, the correlation coefficient doesn’t measure cumulative returns. It only depicts the statistical relationship between each investment’s month-to-month price movements. And second, the category performance represents the market-weighted average of several portfolios. The arbitrage category, for example, comprises five products, four mutual funds and one exchange traded fund (ETF). Market weighting gives us insight into investor behavior and allows us to more clearly see how investors are actually putting their capital to work. The stand-out arb portfolio is the relatively small Quaker Event Arbitrage Fund (MUTF: QEAAX ) with a correlation of -0.21 to AGG and an average annual return of 2.39 percent. QEAAX deals in mergers, takeovers, spin-offs and other reorganizations, hoping to capture securities mispricings. The obvious problem with QEAAX, if a problem is to be found, is its high correlation to equities. QEAAX, after all, buys and sells stocks. If the prospect of rising rates spooks the equity market, as indeed it seems to have done, the Quaker fund’s NAV will likely be pressured. Hedged equity funds are also highly correlated to the broad stock market. The “hedge” in the category’s title refers to the variety of strategies employed by constituent funds to attenuate, but not necessarily eliminate, beta. The Schooner Fund (MUTF: SCNAX ), for example, is a long-biased fund that utilizes a buy-write (covered call) strategy to boost income. That said, SCNAX, with a -0.19 correlation to AGG, benefits most from a mildly bullish equity market. SCNAX pays just 0.57 percent in dividends. Commodity funds-long-only indexed portfolios-are only modestly correlated to stocks, but are suffering from a four-year disinflationary malaise. All, save one, are negatively correlated with AGG. It’s the PIMCO Commodity Real Return Strategy Fund (MUTF: PCRIX ), which overlays an actively managed fixed income strategy atop the index portfolio, that earns a 0.04 correlation to AGG. It should come as no surprise that long/short equity funds are highly correlated to the broad stock market. Nearly half of the 16 funds in the category, in fact, correlate to the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) at better than 0.85. Of these, one with the most negative correlation to AGG (-0.31) is the Diamond Hill Long-Short Fund (MUTF: DIAMX ), a portfolio that commands a 22 percent share of the category. Market-neutral funds attempt to hedge out general market exposure, i.e., aim for a beta near zero, to allow full expression of the manager’s concentrated bets. The multi-manager Deutsche Diversified Market Neutral Fund (MUTF: DDMIX ) accomplishes this with the category’s most negative correlation to AGG (-0.16). Alternative Income There’s a category we haven’t yet examined: alternative income. Three funds, in particular, have five-year track records, two mutual funds and an ETF. Collectively, these funds exhibit a modestly negative correlation (-0.06) to AGG, though you can see there’s a fair degree of “zig” to AGG’s “zag” in Chart 2. Viewed separately, these funds offer distinct value propositions: The $7.6 billion ALPS Alerian MLP ETF (NYSEARCA: AMLP ) tracks the price and yield performance of the Alerian MLP Infrastructure Index, a modified capitalization-weighted and float-adjusted benchmark of two dozen U.S. energy master limited partnerships (MLPs). To allow a full allocation to MLPs, AMLP is structured as a C-corporation, which means it can’t pass through the full return of its underlying index. Payouts are distributed net of corporate tax, which translates into a daunting expense ratio of 5.4 percent. The good news is that most of these distributions come tax-deferred to investors, making its 8.4 percent distribution yield doubly attractive. Worse News There’s, of course, worse news: The energy sector’s tanked this year, taking AMLP’s share price with it. The fund lost 28 percent on the year through mid-November. The JPMorgan Strategic Income Opportunities Fund (MUTF: JSOAX ) is an unconstrained bond fund with an absolute return orientation. The $18.4 billion fund has the flexibility to allocate its assets across a broad range of fixed income securities and derivatives as well as strategies employing cash and short-term investments. JSOAX is not afraid to load up on high-yield securities. JSOAX tends toward a short duration and holds a heavy slug of cash, all of which reduce its interest rate risk. The fund offers a 2.6 percent distribution yield. At $698 million, the Highland Floating Rate Opportunities Fund (MUTF: HFRAX ) is the category’s smallest asset collector. Still, it’s the best performer. HFRAX invests in floating rate bank loans-obligations with interest rates pegged to a spread over Libor (the London Interbank Offered Rate). This puts the fund in the catbird seat in a credit-tightening cycle. Currently, the fund offers a 5 percent distribution yield. You can see in Table 2 the countertrend nature of the HFRAX fund in its -0.22 correlation to AGG and a Sharpe ratio 40 basis points above that of the iShares product. So what have we learned from our little exercise? Simply this: When it comes to hedging interest rate risk, fund performance doesn’t draw assets. At least not yet. The Highland HFRAX fund, despite its impressive metrics, remains relatively obscure. It accounts for barely one-half of 1 percent of the alternative funds’ assets examined here. Perhaps that makes this fund-and newer funds on similar trajectories-undiscovered gems in the upcoming rate environment.