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QUAL: Fundamental Weighting Produced A Surprisingly Reasonable Portfolio

Summary This ETF has a lower expense ratio than I would have predicted for fundamental weighting. The individual holdings look fairly appealing. I was concerned about the presence of a “fundamental weighting” strategy, but I can’t argue with the holdings. The sector allocations are remarkably similar to a total market ETF ran by the same sponsor. 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 researching is the iShares MSCI USA Quality Factor ETF (NYSEARCA: QUAL ). 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 for QUAL is only .15%. I tend to be very frugal with my expense ratios, so I like to see those low levels. When I’m looking at a simple market cap weighted broad market or total market ETF I would expect to see single digit expense ratios. I’m not saying that fundamental weighting strategies are inherently superior, but I sure don’t mind seeing a strategy that is different from the typical market capitalization weights. Comparing this only to other ETFs that are using fundamental weighting strategies, the expense ratio feels fairly reasonable. Largest Holdings The following chart shows the largest holdings for the fund: (click to enlarge) While I’m not entirely sold that fundamental weighting strategies are the perfect answer, I can’t argue with the portfolio produced by those strategies. I’m looking at this portfolio and I see quite a few companies that I like to see in the top holdings. Microsoft Corp. (NASDAQ: MSFT ) is the top weighting and it gets a fairly heft allocation with more than 5% of the portfolio. I’m not huge on Microsoft because I was hoping to be blown away by Windows 10. My machines are still running Windows 7. I don’t want the latest product at a price of “Free upgrade”, which concerns me. On the other hand, I’m still using their operating systems on all of my computers and have not even considered changing, so that is a highly favorable sign. Going down the other holdings I see several companies that I love to see with heavy weights. Johnson & Johnson (NYSE: JNJ ) is an incredible dividend aristocrat and a leader in the health care sector. I’d like to have that kind of exposure so that higher profit margins for the health care sector would at least lead to higher dividends for me to offset higher prices on the products I would need to buy. I’m a little surprised that Wal-Mart (NYSE: WMT ) is not on the list after their share prices fell so hard. Margins are razor thin in the retail industry but if the ratios included price as a factor I would think WMT would get a nod. One very interesting choice in here is Monster Beverage Corp (NASDAQ: MNST ). I am a big fan of Monster and I think they may regularly be undervalued because of the target market for their product not matching up with the section of the population that will own the majority of the stock market. Monster is a young brand. With Coca-Cola Company (NYSE: KO ) helping Monster grow the brand I expect Monster to have some solid international growth. I just wouldn’t expect Monster to still be on this chart after their price soared after Coca-Cola announced their acquisition of part of the company. Sectors The following chart breaks down the allocation by sector: This allocation is interesting to me because it is remarkably similar to the sector allocation of another ETF ran by the same parent company. Below I have a chart of the sector allocation for the iShares Core S&P Total U.S. Stock Market ETF (NYSEARCA: ITOT ). Interesting similarity huh? I would expect that similarity in funds that were simply using market cap weighting, but it is interesting when the fund is using a fundamental weighting. Note that the individual company holdings are substantially different between the two funds, it is just the sector allocations that are remarkably similar. Conclusion I haven’t been entirely sold on the system of fundamental weightings since it suggests that a simple computerized model of large companies would be outperforming the market as a whole. I have a hard time swallowing that pill and prefer to use a somewhat defensive equity allocation for my index funds while focusing my individual security selection on very small companies in sectors that have seen severe market failings because I believe it will be easier for me to beat the market there. Despite my not being entirely sold on the system, the expense ratio isn’t bad and the system produced a group of very respectable companies to lead the portfolio. Over the years I may find my opinions on factors like fundamental weighting to be shifting given the companies that were selected.

Shopping For High Dividend ETFs? Beware Volatility

This article originally appeared in the October issue of REP. Magazine and online at Wealthmanagement.com Yield-starved investors turn to high-dividend payers to squeeze out some cash flow, but how do you squeeze extra yield out of the market without blowing your risk budget? In today’s low-yield bond market, it’s no wonder income-oriented investors have looked to dividends for supplemental cash flows. In February 2011, ten-year Treasury notes were paying nearly two percentage points more than the S&P 500 dividend yield (see Chart 1). The yield premium has since plummeted and, at times, actually turned into a discount. Blue Chips Stalled The ten-year and blue-chip benchmarks are now pretty much stalled at a two percent yield, forcing many investors to cast about for better-paying opportunities. Especially enticing are high-dividend exchange-traded funds (“ETFs”), which offer cash flows nominally devoid of duration and interest rate risk. Seven have track records stretching back more than five years: The 100 stocks making up the iShares Select Dividend ETF (NYSEARCA: DVY ) are screened on the basis of dividend growth and sustainability. Utilities account for more than a third of the portfolio’s capitalization. Financials, mostly REITs, come in second. The 50-stock SPDR Dividend ETF (NYSEARCA: SDY ), which screens the S&P 1500 Composite Index for stocks with 20 years or more of consecutive dividend increases, maintains a narrower portfolio. Consequently, SDY skews heavily toward REITs. Vanguard avoids REITs entirely in its high-dividend product. The 400+ stocks populating the Vanguard High Dividend Yield ETF (NYSEARCA: VYM ) are more or less evenly weighted by sectors and tilt toward large caps. First Trust sponsors two veteran high-dividend ETFs. The larger, First Trust Value Line Dividend ETF (NYSEARCA: FVD ), is built with low-beta issues found with Value Line’s proprietary “safety rating” methodology. Not surprisingly, FVD gives over nearly a quarter of its real estate to utilities. The loose inclusion criteria of the WisdomTree High Dividend ETF (NYSEARCA: DHS ) accounts for its 900+ stock portfolio and its relatively modest sector bets. Still, financials are weighted more heavily than utilities. FVD’s stablemate, the First Trust Morningstar Dividend Leaders Index ETF (NYSEARCA: FDL ), is a 100-stock portfolio comprised of companies that have boosted their dividends over the past five years. REITs are specifically excluded. Accordingly, FDL tilts toward utilities. Rounding out the set is the PowerShares High Yield Equity Dividend Achievers Portfolio ETF (NYSEARCA: PEY ), a 50-stock portfolio of large caps selected on the basis of their ten-year dividend growth histories. Utilities figure heavily in the mix-more so, in fact, than in the other veteran funds. When interest rates sag, income-hungry investors may be tempted to chuck fixed-income exposure in favor of high-dividend funds. That’s a very risky move, however. Remember: These funds are equity products. Replacing all or part of a portfolio’s fixed-income allocation increases exposure to stock market volatility and can further concentrate risk in certain industry sectors. Choices, choices So how do you squeeze some extra yield out of the market without blowing your risk budget? The first step ought to be identifying the high-dividend funds that provide the greatest diversification. There’s a couple of ways to look at this problem. From Table 1, you can see that the First Trust FDL portfolio, in addition to offering the highest dividend yield, has the lowest r-squared and beta correlations versus the S&P 500. That makes FDL pretty different and pretty attractive. FDL, however, posts the worst Sharpe and Sortino ratios of the lot. Not a good thing. The Sharpe metric, remember, rates a fund’s risk-adjusted returns using total volatility. The Sortino ratio does the same thing but only uses downside deviation as the representation of risk. If preservation of capital is paramount, a high-dividend fund sporting the best Sharpe and Sortino ratios ought to be a top pick. That makes the PowerShares PEY fund a standout. The next problem is the allocation issue. Just how much of the high-dividend fund do you add to your portfolio? And, where do you carve out room for it? Here, a little backtesting offers clues. Suppose you’re keen on dampening risk as much as possible while keeping your commitment to a high-dividend product at 20 percent of your capital. Let’s look back at the last five years to see how PEY might have performed. Classic 60/40 Portfolio Our benchmark will be a classic “60/40” portfolio: 60 percent stocks, represented by the SPDR S&P 500 ETF (NYSEARCA: SPY ), and 40 percent bonds, proxied by the iShares Core Aggregate Bond ETF (NYSEARCA: AGG ). Taking a 20 percent PEY carve-out from the bond side (a “60/20/20” allocation) produces a significantly higher average annual return than the benchmark but yields an inferior Sortino ratio. Splitting the PEY carve-out equally from the equity and bond sides (a “48/32/20” mix) improves both nominal and risk-adjusted returns but ticks up volatility. The sweet spot’s found by carving out a PEY allocation from the classic portfolio’s equity side (a “40/40/20” exposure). There’s a minimal impact on the portfolio’s average annual return but a significant reduction in volatility and, therefore, realized risk. Both risk ratios, especially the Sortino metric, are dramatically improved at the cost of just 10 basis points in annualized returns. High div/low vol packages Some newer high-dividend ETFs attempt to entice risk-averse investors by branding themselves as “low-volatility” portfolios. The oldest of these, launched in 2012, is the PowerShares S&P 500 High Dividend Portfolio ETF (NYSEARCA: SPHD ). SPHD’s index methodology screens the S&P 500 for 50 of the blue-chip benchmark’s highest-paying and least-volatile components, tilting the portfolio heavily toward utilities, consumer staples and financials. At last look, SPHD paid out a 3.5 percent dividend. It’s no surprise that SPHD is highly correlated to its parent index. Movements in the S&P 500 explain 77 percent of SPHD’s variance. SPHD’s beta, at .76, makes the fund a middling competitor to the veteran high-dividend products. Using SPHD in a “40/40/20” portfolio pares 50 basis points off the return earned by a classic “60/40” portfolio and an equal amount from the portfolio’s volatility. The significant improvement in the portfolio’s Sortino ratio bespeaks SPHD’s defensive sector concentration. SPHD isn’t the only ETF claiming low-vol street cred. The Global X SuperDividend US ETF (NYSEARCA: DIV ) is another 50-stock portfolio that screens stocks for low volatility, but its universe includes MLPs and REITs. Thus, the fund’s high-dividend yield is north of seven percent. The fund’s equal-weighting scheme magnifies the energy and financial sectors’ influence, which perhaps explains why a portfolio including DIV has Sharpe and Sortino ratios worse than a classic “60/40” mix. As with anything, it pays to look beyond the advertising for real evidence. Volatility is relative. Investors will soon have another exchange-traded high-div/low-vol option. Legg Mason recently filed a registration statement for an ETF based on the QS Low Volatility High Dividend Index, a proprietary benchmark that culls 3,000 domestic stocks for sustainable dividends as well as low earnings and price volatility. The Legg Mason Low Volatility High Dividend ETF is expected to be listed on Nasdaq, but no ticker symbol has yet been assigned. What’s clear from this exercise is that dividends come at a cost. Each high-dividend fund is constructed differently, and each presents a unique combination of risks and rewards. The highest-yielding product may not be the best addition to your portfolio. It’s often better to accept a more modest cash flow than risk hard-earned capital.