Tag Archives: management

Want Some New Geography In Your Portfolio? ECON Is Fairly Unique

Summary ECON is heavily focused on consumer goods and services across the emerging markets. The holdings are unfortunately heavily concentrated into single companies. The companies come from a very diverse group of countries that offer investors exposure that they would struggle to replicate. The high expense ratio creates a problem from long term returns but investors could use the fund with tolerance bands to ensure buying low and selling high. One of the funds I’m examining is the EGShares Emerging Markets Consumer ETF (NYSEARCA: ECON ). 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 is a massive .83%. That is just incredibly heavy, but we should keep looking through the fund to see what is unique about the ETF. Industry (click to enlarge) The sector exposure is fairly simple. I’d rather see a further break down within the Consumer Goods and Consumer Services to establish “Staples” relative to “Discretionary” firms. I would be more interested in using an international ETF that focused on consumer staples than consumer discretionary companies. Largest Holdings (click to enlarge) The largest holding is over 10% of the portfolio and the rest of the top 10 are all greater than 3.5%. Investors may start to wonder where the expense ratio is going because it shouldn’t be going to trading expenses when the portfolio is so complicated. Geography (click to enlarge) This is easily the best part of the portfolio in my opinion. With the exception of China you aren’t likely to find many ETFs that are going to overweight the rest of these countries. The nice thing about this selection is that it creates excellent diversification. The one drawback to using diversification this way is that correlations increase dramatically during periods of crisis so the actual benefits to the portfolio value during a major correction won’t be as substantial as it should be. The other concern here is that I don’t like seeing China as a major weighting here. I’ve been a bear on China since summer. Their market moved up dramatically earlier in the year and has been correcting fairly hard. I’d rather avoid that source of risk in the current environment, but a few months can dramatically move prices and result in a very different assessment. Aside from my concerns about the Chinese economy, I would give this ETF a very solid 10 of 10 on incorporating countries that are often very low weights in an investor portfolio. Keep in mind that these emerging markets should be a fairly small weight in the investor portfolio, so a heavy allocation to ECON would be extremely dangerous. This kind of geographic diversification should be limited to no more than 5% to 10% of the portfolio, but I would want investors to be very aware of the risks before they went towards that 10% allocation. Building the Portfolio The sample portfolio I ran for this assessment is one that came out feeling a bit awkward. I’ve had some requests to include biotechnology ETFs and I decided it would be wise to also include a the related field of health care for a comparison. Since I wanted to create quite a bit of diversification, I put in 9 ETFs plus the S&P 500. The resulting portfolio is one that I think turned out to be too risky for most investors and certainly too risky for older investors. Despite that weakness, I opted to go with highlighting these ETFs in this manner because I think it is useful to show investors what it looks like when the allocations result in a suboptimal allocation. The weightings for each ETF in the portfolio are a simple 10% which results in 20% of the portfolio going to the combined Health Care and Biotechnology sectors. Outside of that we have one spot each for REITs, high yield bonds, TIPS, emerging market consumer staples, domestic consumer staples, foreign large capitalization firms, and long term bonds. The first thing I want to point out about these allocations are that for any older investor, running only 30% in bonds with 10% of that being high yield bonds is putting yourself in a fairly dangerous position. I will be highlighting the individual ETFs, but I would not endorse this portfolio as a whole. 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 10.00% 2.11% Health Care Select Sect SPDR ETF XLV 10.00% 1.40% SPDR Biotech ETF XBI 10.00% 1.54% iShares U.S. Real Estate ETF IYR 10.00% 3.83% PowerShares Fundamental High Yield Corporate Bond Portfolio ETF PHB 10.00% 4.51% FlexShares iBoxx 3-Year Target Duration TIPS Index ETF TDTT 10.00% 0.16% EGShares Emerging Markets Consumer ETF ECON 10.00% 1.34% Fidelity MSCI Consumer Staples Index ETF FSTA 10.00% 2.99% iShares MSCI EAFE ETF EFA 10.00% 2.89% Vanguard Long-Term Bond ETF BLV 10.00% 4.02% Portfolio 100.00% 2.48% The next chart shows the annualized volatility and beta of the portfolio since October of 2013. (click to enlarge) Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. You can see immediately since this is a simple “equal weight” portfolio that XBI is by far the most risky ETF from the perspective of what it does to the portfolio’s volatility. You can also see that BLV has a negative total risk impact on the portfolio. When you see negative risk contributions in this kind of assessment it generally means that there will be significantly negative correlations with other asset classes in the portfolio. The position in TDTT is also unique for having a risk contribution of almost nothing. Unfortunately, it also provides a weak yield and weak return with little opportunity for that to change unless yields on TIPS improve substantially. If that happened, it would create a significant loss before the position would start generating meaningful levels of income. A quick rundown of the portfolio 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 Health Care Select Sect SPDR ETF XLV Hedge Risk of Higher Costs SPDR Biotech ETF XBI Increase Expected Return iShares U.S. Real Estate ETF IYR Diversify Domestic Risk PowerShares Fundamental High Yield Corporate Bond Portfolio ETF PHB Strong Yields on Bond Investments FlexShares iBoxx 3-Year Target Duration TIPS Index ETF TDTT Very Low Volatility EGShares Emerging Markets Consumer ETF ECON Enhance Foreign Exposure Fidelity MSCI Consumer Staples Index ETF FSTA Reduce Portfolio Risk iShares MSCI EAFE ETF EFA Enhance Foreign Exposure Vanguard Long-Term Bond ETF BLV Negative Correlation, Strong Yield 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 ECON has some very interesting geographical concentrations. While the regression shows a fairly high correlation with the S&P 500, the ETF has had a very weak return over the last 5 years which is precisely the opposite of what I would say about the S&P 500. When comparing the correlation between returns, occasionally unrelated assets can appear to have a substantially higher level of correlation due to the daily measurements of returns or due to negative shocks creating a bias in the data. The correlation with EFA is fairly strong though. Investors using ECON would be wise to take advantage of temporary deviations by preparing a plan to rebalance in advance. Ideally that plan would focus on tolerance ranges rather than the frequency of rebalancing. In short, if they assigned a 5% allocation to ECON, they might rebalance the position whenever it exceeded 6% of the portfolio or fell below 4% of the portfolio. While I like the geographic diversification in this portfolio, it is not enough to justify paying a substantially higher expense ratio. Over the longer term, I think the best chance for this ETF to provide solid returns is for shareholders to plan to use the rebalancing strategy to ensure that they are buying in low and selling high. If an investor is willing to rebalance that way and accept modern portfolio theory, it would be ironic if they still felt that a very high expense ratio fund was going to offer superior returns over the long haul.

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.

XLE: Energy Stocks Still Overvalued Relative To The Oil Price

Oil may find a bottom this fall at $35-$40 — but that doesn’t mean oil stocks will find a bottom. The XLE energy stock ETF remains highly inflated, as compared with the oil price. Oil and the broader stock market have been trading together since volatility spiked in August. If the S&P 500 goes down another leg to the 1680 range this fall, XLE will fall even farther than the S&P and the oil price will. Don’t buy oil stocks yet — in fact, consider shorting XLE. Ever since the oil price crashed in the fall of 2014, investors have been trying to call a bottom and find an opportunity to invest in the energy sector at bargain values. But so far, the market has frustrated would-be value investors in energy, as the oil price and energy stocks of all types have continued to fall farther and farther. The low to date was reached in the market selloff of August 24-25, when WTIC oil settled at $38.22 and the Energy Select Sector SPDR ETF (NYSEARCA: XLE ) fell to $59.22. Some investors are now hopeful that these prices were the bottom that they have been waiting for, and they think now is finally the time to buy energy stocks and make big profits on the oil price rebound in the coming years. I believe they are half right, but unfortunately it is not the most profitable half. The oil price itself was probably very close to the bottom when it fell into the $37-$40 range for a few days, below $40 for the first time since February 2009. But the large-cap and mid-cap energy stocks in XLE probably have a lot farther to fall. XLE was in the low $40s in February 2009, and it could fall another 33% from its current price before it reaches that level again. The point is that large-cap and mid-cap energy stock prices are influenced both by the oil price and by the performance of the broader stock market in general. Their prices were very low in February 2009 because the oil price and all stock prices were very low. Their prices held up relatively quite well from fall 2014 through spring 2015 because the whole stock market was holding up well then. Investors had confidence that the big oil companies would ride out the oil price drop and continue to prosper along with the entire economy when oil prices recovered. But since the return of volatility in all markets since August, oil stocks no longer have the assurance of the broader market to fall back on. Stocks have dropped decisively from their highs earlier in 2015, and the technical charts point to further declines coming this fall, which of course is a historically weak seasonal period for stocks. Numerous technical indicators signal that if the S&P 500 cannot hold support in the 1820-1867 range, a drop all the way to 1680 is the next likely step down. Moreover, in the current period of volatility, stocks and oil are trading together. When one goes down, so does the other. A bearish market trend and linkage of stocks and oil is very, very bad news for the energy stocks in XLE. One chart shows clearly how much more room XLE has to fall: (click to enlarge) This chart shows the ratio of the share price of XLE to the actual price of WTIC oil, over the entire history of XLE as an ETF, from 1999 to the present. Notice how elevated the XLE price remains today, as compared with the oil price. The ratio has retreated from its all-time highs earlier this year, but it still remains very high compared to most of the past decade and a half. If the broader stock market takes another turn for the worse, this charts shows that XLE has plenty of room to fall along with it, even after the oil price itself nears a bottom and stops falling so steeply. Notice in the chart that until last year, the XLE:$WTIC ratio normally stayed in a range from 0.6 to 0.8. With all stocks in a downward trend, there is no particular reason to expect that XLE will stay elevated above that range, and every reason to expect the likelihood of XLE returning to that range. For example, if the oil price settles at $40 and the XLE:WTIC ratio even returns to the top of the old range at 0.8, that would mean an XLE share price of $32, almost a 50% drop from its current price. If the oil price settles at $35 and the ratio falls to the bottom of the old range at 0.6, that would mean an XLE share price of $21, a 66% drop from its current price. I am not predicting that XLE will crash to $21 or even $32 this fall. I am just pointing out that it is well within the realm of reasonable possibility and would not represent an extreme change in the historical performance of XLE relative to the oil price. More likely is a decline to the low $40s or high $30s this fall, the range that XLE fell to in the crash of 2008-2009. The overall stock market would not have to crash 2008-style for XLE energy stocks to fall to those levels. The process will look very different because in 2008, stocks crashed first and then the oil price dropped, whereas this time the oil price dropped first and stocks are falling later. Actions to take: First of all, don’t buy oil stocks yet! The knife is still falling. More aggressive investors can consider shorting XLE. As a hedge, investors can short XLE and buy The United States Oil ETF, LP ( USO) to play a decline in the XLE:$WTIC ratio.