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Which Junk Bond ETF Is Best For 2015? Part 1

Summary JNK has a higher yield and lower expenses. HYG has higher credit quality and lower volatility. JNK and HYG have near identical returns over the past 5 years. Both have seen their payouts decline along with interest rates. The two largest high yield bond funds are the iShares iBoxx $ High Yield Corporate Bond (NYSEARCA: HYG ) and the SPDR Barclays Capital High Yield Bond ETF (NYSEARCA: JNK ). These funds use very similar strategies that result in largely similar portfolios and performance, with a few small variations. Index & Strategy HYG tracks the Markit iBoxx USD Liquid High Yield Index , while JNK tracks the Barclays High Yield Very Liquid Index. These two funds are highly correlated, to the tune of 0.9985 since 2006. Since 2010, the correlation rises to 0.9995. This comparison of some key data points reveals the main differences between the funds. Through January 16, these ETFs had near identical 3-year and 5-year annualized returns. Investors can pocket a little more income with JNK, but total returns are very similar. Along with that slightly higher yield comes a slightly higher duration, making JNK a little more sensitive to changes in interest rates. HYG has more assets and higher average dollar trading volume. The number of shares traded is very similar, but HYG’s price is more than double that of JNK. JNK is cheaper than HYG, to the tune of 0.10 percent a year. Given the similarities between the funds, the difference in cost is a big advantage for JNK. Even though HYG is at disadvantage on cost and yield, it has managed to outperform JNK. In terms of credit quality, JNK has 40 percent in BB rates bonds; 43 percent in B; and 16 percent in CCC or lower. HYG has 48 percent in BB rated bonds; 39 percent in B; and 11 percent in CCC. Performance This price ratio chart of HYG versus JNK shows the funds move in tandem, except during the financial crisis. Over the past 5 years, the two funds have fluctuated within a range of 3 percent of each other. A rising line indicates HYG is outperforming. (click to enlarge) This price ratio chart compares the price performance of HYG and JNK over the past 5 years without adjusting for dividends. It shows that HYG has benefited more from price appreciation than from income, as would be expected given HYG yields less, yet returns the same in the long-run. (click to enlarge) This chart shows their returns since 2010. (click to enlarge) Income JNK has a higher yield than HYG, but both funds have seen their payout decline amid low interest rates (data from the provider websites). (click to enlarge) The chart below shows the trailing 12-month yields based on actual payouts. JNK was paying more at the start in part because shares did under perform during the financial crisis. The main takeaway is that yields were falling due to falling interest rates (rising bond prices) and if that trend continues, investors will continue to see shrinking payouts. (click to enlarge) Risk & Reward JNK has a 3-year beta of 1.17 versus HYG’s beta of 1.09., both versus the BofAML HY Master II Index. JNK has a 3-year standard deviation of 5.33 compared to HYG’s standard deviation of 5.01. This means JNK is slightly more volatile than HYG. Both funds have exposure to the energy sector, with HYG’s provider listing its exposure at 13.82 percent. JNK does not break out its exposure by sector, but given the volatility in that sector, if it had a meaningful difference in exposure, there would be a considerable difference in returns. JNK is down 1.15 percent in the past three months versus a 0.26 percent drop in HYG. High yield bonds are less sensitive to changes in interest rates due to their lower duration, but they are very sensitive to the economy. In 2008, JNK fell 25.67 percent and HYG lost 17.37 percent. The late 2014 plunge in oil prices weighed heavily on junk bond funds. Including dividends, HYG is down about 3 percent over the past seven months, versus the 4 percent decline in JNK. The most recent turnover data from Morningstar shows JNK had turnover of 30 percent as of June 30, 2014, while HYG had turnover of 11 percent as of February 28, 2014. If HYG has historically maintained this lower turnover, this makes the cost gap smaller than the expense ratio indicates, since HYG would face fewer transaction costs. Conclusion JNK and HYG are very similar funds, but they do have their differences. JNK charges less and has a higher yield, but that comes with higher volatility and lower credit quality. HYG manages to consistently deliver nearly the same total return as JNK though. Overall, this makes HYG the more attractive ETF, especially given our position in the economic cycle. A recession isn’t brewing yet, but it has been seven years since the last one began. With better credit quality, HYG is likely to hold up better again in the next recession. Investors will receive a smaller yield from HYG, but this extra bit of income isn’t worth the risk of under performing the next time the high yield bond market suffers a major sell-off. Short-Term High Yield While HYG is a better choice than JNK in 2015, there are more funds to consider. In part 2, we’ll look at the SPDR Barclays Capital Short Term High Yield Bond ETF (NYSEARCA: SJNK ) and the PIMCO 0-5 Year High Yield Corporate Bond Index ETF (NYSEARCA: HYS ).

MDYG Looks Like A Great ETF, I Don’t See A Single Weakness

Summary I’m taking a look at MDYG as a candidate for inclusion in my ETF portfolio. MDYG offers investors enough liquidity to reduce risks of being stuck in an undesired position. The liquidity, in my opinion, is better than it appears from trading volume. The correlation is respectable and based off a strong enough level of liquidity that I have some confidence in the statistics. From the diversification to the expense ratio, I can’t find a single problem. I don’t intend to focus on “growth” companies, but I might make a small niche for MDYG. I’m not assessing any tax impacts. Investors should check their own situation for tax exposure. How to read this article : If you’re new to my ETF articles, just keep reading. If you have read this intro to my ETF articles before, skip down to the line of asterisks. This section introduces my methodology. By describing my method initially, investors can rapidly process each ETF analysis to gather the most relevant information in a matter of minutes. My goal is to provide investors with immediate access to the data that I feel is most useful in making an investment decision. Some of the information I provide is readily available elsewhere, and some requires running significant analysis that, to my knowledge, is not available for free anywhere else on the internet. My conclusions are also not available anywhere else. What I believe investors should know My analysis relies heavily on Modern Portfolio Theory. Therefore, I will be focused on the statistical implications of including a fund in a portfolio. Since the potential combinations within a portfolio are practically infinite, I begin by eliminating ETFs that appear to be weak relative to the other options. It would be ideal to be able to run simulations across literally billions of combinations, but it is completely impractical. To find ETFs that are worth further consideration I start with statistical analysis. Rather than put readers to sleep, I’ll present the data in charts that only take seconds to process. I include an ANOVA table for readers that want the deeper statistical analysis, but readers that are not able to read the ANOVA table will still be able to understand my entire analysis. I believe there are two methods for investing. Either you should know more than the other people performing analysis so you can make better decisions, or use extensive diversification and math to outperform most investors. Under CAPM (Capital Asset Pricing Model), it is assumed every investor would hold the same optimal portfolio and combine it with the risk free asset to reach their preferred spot on the risk and return curve. Do you know anyone that is holding the exact same portfolio you are? I don’t know of anyone else with exactly my exposure, though I do believe there are some investors that are holding nothing but SPY. In general, I believe most investors hold a portfolio that has dramatically more risk than required to reach their expected (under economics, disregarding their personal expectations) level of returns. In my opinion, every rational investor should be seeking the optimal combination of risk and reward. For any given level of expected reward, there is no economically justifiable reason to take on more risk than is required. However, risk and return can be difficult to explain. Defining “Risk” I believe the best ways to define risk come from statistics. I want to know the standard deviation of the returns on a portfolio. Those returns could be measured daily, weekly, monthly, or annually. Due to limited sample sizes because some of the ETFs are relatively new, I usually begin by using the daily standard deviation. If the ETF performs well enough to stay on my list, the next levels of analysis will become more complex. Ultimately, we probably shouldn’t be concerned about volatility in our portfolio value if the value always bounced back the following day. However, I believe that the vast majority of the time the movement today tells us nothing about the movement tomorrow. While returns don’t dictate future returns, volatility over the previous couple years is a good indicator of volatility in the future unless there is a fundamental change in the market. Defining “Returns” I see return as the increase over time in the value known as “dividend adjusted close”. This value is provided by Yahoo. I won’t focus much on historical returns because I think they are largely useless. I care about the volatility of the returns, but not the actual returns. Predicting returns for a future period by looking at the previous period is akin to placing a poker bet based on the cards you held in the previous round. Defining “Risk Adjusted Returns” Based on my definitions of risk and return, my goal is to maximize returns relative to the amount of risk I experienced. It is easiest to explain with an example: Assume the risk free rate is 2%. Assume SPY is the default portfolio. Then the risk level on SPY is equal to one “unit” of risk. If SPY returns 6%, then the return was 4% for one unit of risk. If a portfolio has 50% of the risk level on SPY and returns 4%, then the portfolios generated 2% in returns for half of one unit of risk. Those two portfolios would be equal in providing risk adjusted returns. Most investors are fueled by greed and focused very heavily on generating returns without sufficient respect for the level of risk. I don’t want to compete directly in that game, so I focus on reducing the risk. If I can eliminate a substantial portion of the risk, then my returns on a risk adjusted basis should be substantially better. Belief about yields I believe a portfolio with a stronger yield is superior to one with a weaker yield if the expected total return and risk is the same. I like strong yields on portfolios because it protects investors from human error. One of the greatest risks to an otherwise intelligent investor is being caught up in the mood of the market and selling low or buying high. When an investor has to manually manage their portfolio, they are putting themselves in the dangerous situation of responding to sensationalistic stories. I believe this is especially true for retiring investors that need money to live on. By having a strong yield on the portfolio it is possible for investors to live off the income as needed without selling any security. This makes it much easier to stick to an intelligently designed plan rather than allowing emotions to dictate poor choices. In the recent crash, investors that sold at the bottom suffered dramatic losses and missed out on substantial gains. Investors that were simply taking the yield on their portfolio were just fine. Investors with automatic rebalancing and an intelligent asset allocation plan were in place to make some attractive gains. Personal situation I have a few retirement accounts already, but I decided to open a new solo 401K so I could put more of my earnings into tax advantaged accounts. After some research, I selected Charles Schwab as my brokerage on the recommendation of another analyst. Under the Schwab plan “ETF OneSource” I am able to trade qualifying ETFs with no commissions. I want to rebalance my portfolio frequently, so I have a strong preference for ETFs that qualify for this plan. Schwab is not providing me with any compensation in any manner for my articles. I have absolutely no other relationship with the brokerage firm. Because this is a new retirement account, I will probably begin with a balance between $9,000 and $11,000. I intend to invest very heavily in ETFs. My other accounts are with different brokerages and invested in different funds. Views on expense ratios Some analysts are heavily opposed to focusing on expense ratios. I don’t think investors should make decisions simply on the expense ratio, but the economic research I have covered supports the premise that overall higher expense ratios within a given category do not result in higher returns and may correlate to lower returns. The required level of statistical proof is fairly significant to determine if the higher ratios are actually causing lower returns. I believe the underlying assets, and thus Net Asset Value, should drive the price of the ETF. However, attempting to predict the price movements of every stock within an ETF would be a very difficult and time consuming job. By the time we want to compare several ETFs, one full time analyst would be unable to adequately cover every company. On the other hand, the expense ratio is the only thing I believe investors can truly be certain of prior to buying the ETF. Taxes I am not a CPA or CFP. I will not be assessing tax impacts. Investors needing help with tax considerations should consult a qualified professional that can assist them with their individual situation. The rest of this article By disclosing my views and process at the top of the article, I will be able to rapidly present data, analysis, and my opinion without having to explain the rationale behind how I reached each decision. The rest of the report begins below: ******** (NYSEARCA: MDYG ): SPDR® S&P 400 Mid Cap Growth ETF Tracking Index: S&P MidCap 400 Growth Index Allocation of Assets: At least 80% to securities in the index Morningstar® Category: Mid-Cap growth Time period starts: April 2012 Time period ends: December 2014 Portfolio Std. Deviation Chart: (click to enlarge) (click to enlarge) Correlation: 85.22% Returns over the sample period: (click to enlarge) Liquidity (Average shares/day over last 10): About 17,000 Days with no change in dividend adjusted close: 10 Days with no change in dividend adjusted close for SPY: 5 Yield: .88% Distribution Yield Expense Ratio: .25% Discount or Premium to NAV: .16% premium Holdings: (click to enlarge) Further Consideration: Definitely Conclusion: MDYG comes out of this looking fairly reasonable. It isn’t my goal to put a growth weighting into my portfolio, but the correlation is respectable, the liquidity is solid, and the expense ratio is reasonable. While liquidity of 17,000 isn’t huge, the dividend adjusted close was regularly changing. Out of the 10 days in which the dividend adjusted close did not change, there were 5 in which the trading volume was actually 0 for the day. In my opinion, that’s enough liquidity to be worthy of consideration. The yield isn’t very high, but I can deal with that. If I wanted to orient my portfolio towards growth rather than value I think MDYG would be a very strong contender. Due to the orientation I want, if I use MDYG it will be a fairly small position and I will have to compare it directly with a few other ETFs that focus on growth. For my investing style, the ideal exposure is probably around 5%. The best thing for the ETF is probably the complete lack of red flags that I’ve seen. There is no single factor that I can point out as a problem. In my opinion, any ETF that comes out of this with 0 intrinsic weaknesses deserves some consideration. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis. The analyst holds a diversified portfolio including mutual funds or index funds which may include a small long exposure to the stock.

Be Knowledgeable About Liquidity, Don’t Get Fooled By KNOW

Summary I’m taking a look at KNOW as a candidate for inclusion in my ETF portfolio. The average volume looks high enough that the low correlation would seem reliable. Checking the historical data on volume shows that there were a striking number of days with no trades recorded. Despite the interesting concept and strong returns so far, I’m not fond of a very high expense ratio being combined with an ETF that frequently sees a volume of 0. I’m not assessing any tax impacts. Investors should check their own situation for tax exposure. How to read this article : If you’re new to my ETF articles, just keep reading. If you have read this intro to my ETF articles before, skip down to the line of asterisks. This section introduces my methodology. By describing my method initially, investors can rapidly process each ETF analysis to gather the most relevant information in a matter of minutes. My goal is to provide investors with immediate access to the data that I feel is most useful in making an investment decision. Some of the information I provide is readily available elsewhere, and some requires running significant analysis that, to my knowledge, is not available for free anywhere else on the internet. My conclusions are also not available anywhere else. What I believe investors should know My analysis relies heavily on Modern Portfolio Theory. Therefore, I will be focused on the statistical implications of including a fund in a portfolio. Since the potential combinations within a portfolio are practically infinite, I begin by eliminating ETFs that appear to be weak relative to the other options. It would be ideal to be able to run simulations across literally billions of combinations, but it is completely impractical. To find ETFs that are worth further consideration I start with statistical analysis. Rather than put readers to sleep, I’ll present the data in charts that only take seconds to process. I include an ANOVA table for readers that want the deeper statistical analysis, but readers that are not able to read the ANOVA table will still be able to understand my entire analysis. I believe there are two methods for investing. Either you should know more than the other people performing analysis so you can make better decisions, or use extensive diversification and math to outperform most investors. Under CAPM (Capital Asset Pricing Model), it is assumed every investor would hold the same optimal portfolio and combine it with the risk free asset to reach their preferred spot on the risk and return curve. Do you know anyone that is holding the exact same portfolio you are? I don’t know of anyone else with exactly my exposure, though I do believe there are some investors that are holding nothing but SPY. In general, I believe most investors hold a portfolio that has dramatically more risk than required to reach their expected (under economics, disregarding their personal expectations) level of returns. In my opinion, every rational investor should be seeking the optimal combination of risk and reward. For any given level of expected reward, there is no economically justifiable reason to take on more risk than is required. However, risk and return can be difficult to explain. Defining “Risk” I believe the best ways to define risk come from statistics. I want to know the standard deviation of the returns on a portfolio. Those returns could be measured daily, weekly, monthly, or annually. Due to limited sample sizes because some of the ETFs are relatively new, I usually begin by using the daily standard deviation. If the ETF performs well enough to stay on my list, the next levels of analysis will become more complex. Ultimately, we probably shouldn’t be concerned about volatility in our portfolio value if the value always bounced back the following day. However, I believe that the vast majority of the time the movement today tells us nothing about the movement tomorrow. While returns don’t dictate future returns, volatility over the previous couple years is a good indicator of volatility in the future unless there is a fundamental change in the market. Defining “Returns” I see return as the increase over time in the value known as “dividend adjusted close”. This value is provided by Yahoo. I won’t focus much on historical returns because I think they are largely useless. I care about the volatility of the returns, but not the actual returns. Predicting returns for a future period by looking at the previous period is akin to placing a poker bet based on the cards you held in the previous round. Defining “Risk Adjusted Returns” Based on my definitions of risk and return, my goal is to maximize returns relative to the amount of risk I experienced. It is easiest to explain with an example: Assume the risk free rate is 2%. Assume SPY is the default portfolio. Then the risk level on SPY is equal to one “unit” of risk. If SPY returns 6%, then the return was 4% for one unit of risk. If a portfolio has 50% of the risk level on SPY and returns 4%, then the portfolios generated 2% in returns for half of one unit of risk. Those two portfolios would be equal in providing risk adjusted returns. Most investors are fueled by greed and focused very heavily on generating returns without sufficient respect for the level of risk. I don’t want to compete directly in that game, so I focus on reducing the risk. If I can eliminate a substantial portion of the risk, then my returns on a risk adjusted basis should be substantially better. Belief about yields I believe a portfolio with a stronger yield is superior to one with a weaker yield if the expected total return and risk is the same. I like strong yields on portfolios because it protects investors from human error. One of the greatest risks to an otherwise intelligent investor is being caught up in the mood of the market and selling low or buying high. When an investor has to manually manage their portfolio, they are putting themselves in the dangerous situation of responding to sensationalistic stories. I believe this is especially true for retiring investors that need money to live on. By having a strong yield on the portfolio it is possible for investors to live off the income as needed without selling any security. This makes it much easier to stick to an intelligently designed plan rather than allowing emotions to dictate poor choices. In the recent crash, investors that sold at the bottom suffered dramatic losses and missed out on substantial gains. Investors that were simply taking the yield on their portfolio were just fine. Investors with automatic rebalancing and an intelligent asset allocation plan were in place to make some attractive gains. Personal situation I have a few retirement accounts already, but I decided to open a new solo 401K so I could put more of my earnings into tax advantaged accounts. After some research, I selected Charles Schwab as my brokerage on the recommendation of another analyst. Under the Schwab plan “ETF OneSource” I am able to trade qualifying ETFs with no commissions. I want to rebalance my portfolio frequently, so I have a strong preference for ETFs that qualify for this plan. Schwab is not providing me with any compensation in any manner for my articles. I have absolutely no other relationship with the brokerage firm. Because this is a new retirement account, I will probably begin with a balance between $9,000 and $11,000. I intend to invest very heavily in ETFs. My other accounts are with different brokerages and invested in different funds. Views on expense ratios Some analysts are heavily opposed to focusing on expense ratios. I don’t think investors should make decisions simply on the expense ratio, but the economic research I have covered supports the premise that overall higher expense ratios within a given category do not result in higher returns and may correlate to lower returns. The required level of statistical proof is fairly significant to determine if the higher ratios are actually causing lower returns. I believe the underlying assets, and thus Net Asset Value, should drive the price of the ETF. However, attempting to predict the price movements of every stock within an ETF would be a very difficult and time consuming job. By the time we want to compare several ETFs, one full time analyst would be unable to adequately cover every company. On the other hand, the expense ratio is the only thing I believe investors can truly be certain of prior to buying the ETF. Taxes I am not a CPA or CFP. I will not be assessing tax impacts. Investors needing help with tax considerations should consult a qualified professional that can assist them with their individual situation. The rest of this article By disclosing my views and process at the top of the article, I will be able to rapidly present data, analysis, and my opinion without having to explain the rationale behind how I reached each decision. The rest of the report begins below: ******** (NYSEARCA: KNOW ): Direxion All Cap Insider Sentiment Shares Tracking Index: Sabrient Multi-Cap Insider/Analyst Quant-Weighted Index Allocation of Assets: At least 80% within the index Morningstar® Category: Mid-Cap Blend Time period starts: April 2012 Time period ends: December 2014 Portfolio Std. Deviation Chart: (click to enlarge) (click to enlarge) Correlation: 62.75% Returns over the sample period: (click to enlarge) Liquidity (Average shares/day over last 10): About 10,000 Days with no change in dividend adjusted close: 180 Days with no change in dividend adjusted close for SPY: 5 Yield: 1.13% Distribution Yield Expense Ratio: Gross 1.69% and Net 0.65% Discount or Premium to NAV: 0.06% premium Holdings: (click to enlarge) Further Consideration: Yes Conclusion: KNOW is a very interesting and aptly named ETF. The ETF is investing by tracking movements by insiders. It is an interesting strategy and an ETF that automates the strategy may provide much lower costs than an investor attempting to use the strategy by themselves. While I’m not convinced that the strategy works any better than holding SPY, I find the idea of doing it through an ETF novel so I will keep it on the list. If there is actually a lower correlation because of movements in the positions it could be a useful ETF under modern portfolio theory. However, despite an average trading volume of over 10,000 shares, there were 180 days with no change in the dividend adjusted close. I thought that was strange so I ran a volume test over the period checking for days in which 0 shares were traded. There were 174 days in which that happened. That reinforces the theory that despite decent trading volumes in the average over the last 10 days, the calculated correlation has been dramatically altered by liquidity that is much worse than it would have seemed at first glance. In this case I would advise investors to be very wary of relying on the average volume as a sole indicator of liquidity. The distribution yield may be subject to change as the holdings of the ETF change, so I wouldn’t recommend this for anyone needing a consistent yield out of their portfolio. As any of my frequent readers know, I won’t be a fan of the expense ratio. I recognize that the ETF may have significantly more trading costs to cover because of their strategy, but I don’t like seeing values that are so high. The net expense ratio is substantially below the gross expense ratio because of waivers and reimbursement policies in place through September 1st, 2015. I can deal with poor liquidity in the sense of weak average volume, but the frequency of a recorded volume of 0 combined with the expense ratios make it unlikely that KNOW will survive the next round of cuts, even though I’m putting it through to the second round for now. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis. The analyst holds a diversified portfolio including mutual funds or index funds which may include a small long exposure to the stock.